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 towards 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 in the policies it puts into 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 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. These models are used extensively in company valuation for mergers and acquisitions, leveraged buyout, or business valuation.
Industry Specific Model
An industry specific model can be extremely detailed and completed. It takes into account all the unique aspects of an industry (like real estate, oil and gas, mining, financial institutions, ecommerce, etc.) and models them out in Excel. This type of financial model requires a lot a of industry expertise and experience, especially when making input assumptions for the business.
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 the above variables are created for the business, the 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 and individual segments, and refinancing and 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 quantitative decisions, the company must have a reason as to why and what they are wanting to measure in relations to the company’s performance in the first place. 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: