What is a Financial Model?
A financial model is the summary of a company’s performance, based on certain variables, that helps the business forecast future financial performance. In other words, it helps a company see the likely financial results of a decision in quantitative terms. The measurements and skills used to construct the model include knowledge of the company’s operations, accounting, corporate finance, and Excel spreadsheets.
These models are an amalgamation of those skills and are put together based on performance and then used to analyze how a business will react to different economic situations or events. These are commonly used to estimate the outcome of a specific financial decision before the company commits any funds or efforts toward it. To learn more, see our guide to financial modeling.
Types of Financial Models
A financial model takes the following mathematical representations into consideration – cash flow projections, depreciation schedules, debt service, inventory levels, rate of inflation, etc. These variables are then tested via various outputs to determine the impact of a change in one variable or another. This allows the company to really quantify its decisions as to the policies it puts in place, the financial obligations it makes, and the restrictions imposed by investors or lenders. A great example of a basic financial model is a cash budget.
There are various types of financial models, as outlined in more detail in our article exclusively on the subject. When asking yourself “what is a financial model” is also important to ask, “what types are there”?
This is the basic building block financial model. It takes the 3 financial statements and links them together in Excel to make a dynamically linked financial model that connects the income statement, balance sheet, and cash flow statement.
This type of financial model builds on the three statement model described above. It takes the analysis one step further by layering on discounted cash flow (DCF) analysis to determine what the value of the business is. DCF models are used extensively in company valuation for mergers and acquisitions, leveraged buyouts, or business valuations.
An industry-specific model can be extremely detailed and complex. It takes into account all the unique aspects of an industry (e.g., real estate, oil and gas, mining, financial institutions, ecommerce, etc.) and models them out in Excel. This type of financial model requires a lot of industry expertise and experience, especially when making input assumptions for the business.
Video Overview of the Types of Models
Check out the video below to watch and listen to an overview of the various types of models, their components, and why they are used. You’ll be sure to learn a lot in only a few minutes!
End Goal of a Model
As a financial model shows, evaluates, and projects a company’s performance, its main goal is to virtually re-create the actual business. Once variables are created for the business, analysts are able to input different financial impacts that may change these numbers around. Decisions are then evaluated on a quantitative level. This is done through testing assumptions in order to analyze the impact they may have on the company’s future financial performance. Assumptions that a financial model tests include growth rates, operating margins, product lines, individual segments, and refinancing or recapitalization.
As there are multiple financial models, one must know the purpose or “goal” of creating that model. In other words, in order to really make a model useful for evaluating future decisions, the company must have a reason as to why and what they are wanting to measure in relation to the company’s performance. Once it is determined what the model is being used for, a company can determine the proper design and functionality of that model to produce the needed results.
We hope this has helped you understand, “What is a financial model?” While the three core statements are the backbone of the financial model, the depreciation schedule is one of many supporting schedules that help solidify a model. Read more about other types of supporting schedules: