Financial Modelling: Meaning, Types, Importance & How It Works

Among the several aspects of running a successful business is the accurate forecast of its future financial performance. After all, it is a company’s financial performance that plays a vital role in its growth and attracting investors.

However, have you ever thought about how you can predict a company’s potential financial performance in the future? It is through financial modelling. Read on to know what financial modelling is and its various aspects.

What Is Financial Modelling?

Financial modelling is the process through which you can predict a company’s financial performance in the future. Usually built in Microsoft Excel, it is based on a firm’s historical performance and involves creating a summary of a firm’s expenses and earnings.

Think of it like planning your monthly budget. You write down how much money you expect to earn and how much you might spend. Then you check if you will save money or run short. Financial modelling works in a similar fashion, but for a company.

How Does Financial Modelling Work?

First, jot down what the company earns and what it spends. Once you’ve got those numbers, check what’s leftover. Then dig into the history and look at what the company has made in previous years. With that info, try to figure out if sales will rise or if costs will climb.

Now, piece together the model bit by bit, connecting all the parts. If sales jump, profits should follow. But if expenses start climbing, expect profits to shrink. Basically, when one thing shifts, it pulls the others with it.

Types Of Financial Models

Here are the different types of financial models:

Three-Statement Model

This model brings together three main financial reports of a business, including the:

• Income statement

• Balance sheet

• Cash flow statement

While the income statement shows how much money a business makes and spends over a period of time, the balance sheet shows what a business owns and owes at a certain point in time. The cash flow statement tracks the actual movement of cash, showing where cash is coming from and where it is going.

Discounted Cash Flow Model

Discounted cash flow, or DCF, is a way to figure out what something’s really worth right now by looking at how much cash it’s going to bring in down the road. Basically, money you’ll earn in the future never has the same value as money you already have.

So, first you estimate how much cash a business is likely to make over the next few years usually by checking its past track record and what it plans to do. After that, you adjust those future cash numbers, making them smaller, since they’re not in your pocket yet. That’s the “discount” part. You add up all discounted cash values to understand the total value of the business.

Mergers & Acquisitions Model

A mergers and acquisitions (M&A) model is a simple way to check what happens when one company buys another company. It helps you analyse if the deal makes sense or not. You use it to understand if the buying company will earn more money after the deal.

Let’s say Company A wants to buy Company B. The model starts by looking at both companies on their own. The model tracks money coming in, money going out, and the profit left over.

Budgeting & Forecasting Models

This kind of financial model brings together two simple ideas. One is a fixed yearly budget. Then there’s the plan that keeps changing as the year goes on known as forecasting. If you put the two together, you start to see what the future might really look like.

The company creates a yearly budget at the very beginning, based on what they expect to earn and spend. They don’t usually change it much.

But let’s be real, things shift. Sales rise or drop. Costs jump around. Surprises happen, both good and bad. That’s when the updated forecast matters. It helps everyone stay on track, no matter what comes up. It is checked and changed again and again. It uses the latest numbers and adjusts the plan.

Importance Of Financial Modelling

Financial modelling is important in several ways, including:

• Helps In Planning Ahead

Businesses can plan their future through financial modelling. It helps them understand how much money may come in and go out over time. This helps set clear goals.

• Aids In Decision-Making

Financial modelling can give a clear picture before undertaking any big decision like starting a new business branch or investing in something costly. It can help decision-makers avoid mistakes.

• Risk Management

Every business faces risks. Financial modelling can help check different situations, like what if sales drop or expenses increase. This helps in finding problems early and dealing with them.

Who Uses Financial Modelling?

Financial modelling is used by:

Investment Bankers

Investment bankers use financial models to understand a company’s value, particularly during mergers. If two companies want to join forces, bankers need the model to see if the deal adds up.

Financial Analysts

Financial analysts dive into models to check the numbers, look at how things went in the past, and predict what’s next. They use all this info to recommend whether someone should invest in a company.

Corporate Finance Teams

The corporate finance team uses financial modelling to plan budgets, track spending, and make decisions like hiring, expansion, or cutting costs. The model helps them see where the company’s headed.

Startups And Investors

Financial modelling is essential for planning the growth and mapping out the future of startups. As they are new, they need to show how their idea can make money in the future to potential investors. On the other hand, investors look at these models before investing their money. It helps them decide if the startup is worth the risk.

Conclusion

Financial modelling, if done the right way, can help businesses accurately project their future performance. As an investor, it can help you better understand whether you should invest your money in a company or not. In the long-term it leads to better decision-making.