Financial modeling is the function of creating an abstract representation of a financial situation. Financial Models are mathematical models aimed at representing the financial performance of a business entity. In practice, Financial Models are used in budgeting process and cash management. In addition to this, there are other uses of Financial Models which can provide important insights for decision making. With a model we can analyze how much gross profit is necessary to achieve a target result under a given cost structure (variable and fixed costs) (breakeven analysis). As a result, various strategic advantages can be achieved. For the preparation of Financial Models, expertise in various financial areas is required.
Financial Modeling work with simplistic and idealized assumptions to make a projection of Company’s financial position. A good financial model should be as detailed as necessary and as simple as possible.
The key components of a Financial Model :
The main components of Financial Models are the income statement, balance sheet and cash flow statement. Depending on the company structure, separate income statement, balance sheet and cash flow statement may be created for each subsidiary.
Since Financial Models can be very complex, the data flow and the structure of the model must be well considered and planned. The data flow should be uniform throughout the model. Periods of models for example, should always flow from left to right (past, actual, plan) or sums from top to bottom. Furthermore, a well structured Financial Models increases sustainability and the clarity and reduces the error rate.
All information necessary for the model are stored in a file. In general, the creation of a model is divided into four parts.
- Store all necessary raw data in spreadsheets (for example, business reports)
- Make necessary calculations (for example, price-quantity framework).
- Derive results of the Financial Models (for example, the generating cash flow statement).
- Visualization of results (for example, creating graphs and charts).
Advantages of financial modeling :
The benefits of financial modeling are huge. The most important advantage is availability of information for decision making in order to take strategic advantage. Even if a model is based on assumptions, this can help you to estimate the financial results. In a model, different scenarios can be created and tested. Thus, a company can adapt quickly to a changing situation and avoid liquidity risk.
Another advantage of the financial modeling is its flexibility. Experienced Financial Modeller can make extensive changes to a model in a few hours. Another important advantage is the efficiency of the Financial Modeling. Spreadsheet programs are installed by default on most computers and therefore no additional investment is required. In addition, no programming skills are required.
Conclusion: Financial Models can be used to assess future earnings, assets and liquidity situation of a company. So it should be constructed as detailed as necessary and not as easy as possible. Although the financial modeling is anticipated assumptions, it provides a company a number of advantages. It has outstanding insights for strategic decision.