At the core of the various tools used by financial analysts is the financial model. Across the finance industry financial models are built to help with a variety of tasks. Among the many uses of financial models, they are often used to assist in raising capital, making acquisitions, budgeting and forecasting, and in valuation practices.
In this FAQ we will discuss what a financial model is, why they are important to the finance industry as a whole, and some of the more common financial models.
What Is A Financial Model?
A financial model, often referred to as a predictive model, is a forecast of future performance based on a given set of variables. Financial models are used to quantify business expectations of future performance. The models themselves can be different but all financial models are quantitative in nature.
Financial modeling requires a deep knowledge of the various aspects that impact a business. These aspects might include an understanding of the industry as a whole, the product, the market, and the business environment. While the model is quantitative and often objective in its calculations, the assumptions used in a financial model are often subjective and rely on some level of expertise.
The expertise used in the creation of a financial model is just as important as the calculations that are used. This is because a model is only as good as the information and assumptions that it utilizes. Because financial models are used across various industries, each industry has models that are specific to them.
Why Is Financial Modeling Important?
Financial models have a wide range of uses depending on the type of model being used. They are often heavily relied upon in the decision-making process and are used extensively in certain industries for the valuation of assets.
In the context of investment finance, financial models are used to make predictions on the outcomes of mergers and acquisitions and in the valuation of businesses and other assets. For example, discounted cash flow models are often used in the valuation of commercial real estate assets.
Certain financial models are used to analyze the business and perform management accounting, budgeting, and forecasting. One of the primary outputs of the FP&A cycle is a financial model that is used to forecast future results.
Financial modeling has the ability to reduce exposure to risk and is also used to provide a more in-depth understanding of how a business is performing. They are used throughout the corporate performance management (CPM) process to help perform regular performance reviews and are also used to assist with identifying when changes need to be made to operations.
Overall, the financial model is an extremely powerful tool that is relied on throughout many industries to assist in making decisions, reducing risk, adjusting operations, and identifying the optimal allocation of resources.
Three Common Financial Models
While technically a financial model can be created that does something as simple as forecasting cash, there are three primary financial models used across the finance profession. These models account for cash flow projections, depreciation, debt servicing, and other variables that impact financial performance.
Each model takes these variables into account with certain underlying assumptions and uses them to quantify the impact of various plans of action.
The Three Statement Model
A three statement model is a basic financial model that makes predictions on how certain variables will impact the balance sheet, statement of operations, and statement of cash flows. Its name refers to the three financial statements that it relates to.
A three-statement model creates dynamic bonds between these three financial statements and allows users to model what they might look like under certain assumptions. This type of model is especially helpful when trying to gain a comprehensive view of how a certain decision might impact the business.
Discounted Cash Flow Model
A DCF model builds on the three statement model by providing an analysis of a series of discounted cash flows (DCF) to understand what the business’s approximate value is. It is the primary method for valuing most businesses and other cash-flow generating assets, such as commercial real estate, residential rental real estate, and even leasing agreements.
DCF models are the foundational model used across investment finance for a variety of valuation purposes.
Industry-Specific Financial Models
Industry-specific financial models are those models which are far more detailed and complex, pertaining to specific industries and accounting for the nuances in those industries. These models demand a great deal of industry-specific experience and require a deep working knowledge of the industry in order to build accurate and meaningful assumptions. Industries that rely on specific models are oil and gas, real estate, and mining, and mineral extraction.
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