March 18, 2010
Financial Modeling is the task of building an abstract representation of a financial decision making situation. This is a mathematical model, such as a computer simulation, designed to represent the performance of a financial asset or a portfolio, of a business, a project, or any other form of financial investment.
Theoretically speaking, a financial model is a set of assumptions about future business conditions that drive projections of a company’s revenue, earnings, cash flows and balance sheet accounts.
However, Financial Modelling is a general term that means different things to different users. In the US and particularly in business schools it means the development of a mathematical model, often using complex algorithms, and the associated computer implementation to simulate scenarios of financial events, such as asset prices, market movements, portfolio returns and the like. Or it might mean the development of optimization models for managing and controlling the risk of a financial investment. In Europe and in the accounting profession Financial Modelling is defined as cash flow forecasting, involving the preparation of large, detailed spreadsheets for management decision making purposes.
The objective of a financial model is to position clients for success in their foreign investments. What’s the cost of doing business in a given country? What’s the breakeven point? When might you exceed the profitability of a similar operation in the United States?
The importance of Financial Modeling cannot be overstated and Financial Models often are a key element in most major business decisions.
For instance, a Financial Model is prepared whenever any organization is considering project finance, bidding for a project, evaluating acquisition target, carrying out monthly financial planning, conducting capital structure studies, etc.
The proponents of the model must first undertake a qualitative review – i.e. determine whether the story underpinning the model makes sense. There needs to be a logic behind the adoption of the model and a compelling case that it will be supported by its intended target audience.
This useful tool also allows business options and risks to be evaluated in a cost-effective manner against a range of assumptions, identify optimal solutions in evaluating financial returns and understand the impact of resource constraints to make the most effective business decisions.
What is the characteristics of a sound Financial Model?
A good financial model is:
Easy to understand – uses a transparent design
Reliable – uses control checks so that an error is automatically flashed
Easy to use – so that one can be more productive in using the model for analysis rather than struggling just to produce simple results from a badly designed model
Focussed on thekey issues – so that one does not waste too much time in development of immaterial items.