Financial modeling

Financial modeling is the process of building a representation of the real or expected financial development of an entity that enables the company’s management to make the right business decisions. In other words, it is an analysis of the current and future cash flows of the company.

Besides, financial modeling is a tool that allows business executives to understand financial position of the company and its capabilities and forecast how various business decisions may affect a company's stock market performance.

Financial Modeling explained

Financial modeling is defined as a schematic representation of the condition of an enterprise or its elements (the company as a whole or its departments), including financial and non–financial performance indicators. The model allows the company’s management to predict the future performance of the business and evaluate the current and the past financial performance of the company.

Financial modeling makes it possible to get the most accurate analytics on complex situations related to management decision-making. The financial model also represents a plan of revenue and expenses. Such a plan is usually drawn up to assess the effectiveness of an investment or operational decision.

In addition to this, one of the objectives of financial modeling is to inform on the influence of specific events on the securities issued by a company. For instance, it is used to anticipate how switching to a new model will affect a stock.

For business, one of the main criteria for success is profit. Most entrepreneurs do not understand exactly how much they will earn before the end of the year. The financial model makes it possible to predict the future of a business and answer the following question: how much does an existing business cost? Besides, it allows business owners to compare metrics with those of similar companies.

Analytics also carry out financial modeling in strategic planning. Strategic planning is a way of defining the goals of a company and a project in order to understand in which direction to develop. It helps to complete a project cost estimation and resource allocation.

The financial model is intended to solve the following tasks:

modeling of cash flows and assessment of the financial condition of the enterprise.
determination of optimal funding sources and visual representation of resource allocation.
sensitivity analysis to study how specific changes in the external environment will affect a project, as well as analysis of internal risks.
determining the profitability of future projects.

Example

A financial model is built on a set of assumptions. Most often, analytics do financial modeling to forecast sales growth. Revenue growth refers to a difference between a company’s gross sales in the most recent quarter compared to the previous quarter.

The first cell is linked to the total annual sales from the prior year, while the second cell contains information about the sum of the current year. There is a formula in the third cell that divides the difference between the cells. That’s how the sales growth is calculated.

Here, financial modeling is carried out to forecast the level of sales the company will achieve if a certain business or financial decision is made. Financial modeling can be done to any component that influences the growth.