In one of my earlier posts, I have written about the process of development of a financial model and how it is analogous to developing a software. There I covered a significant portion of ‘How’ to develop a financial model.
However, recently I saw Simon Sinek’s Golden Circle TED Talk which talks about key to success being starting with the ‘Why’ instead of ‘What’ or ‘How’. Considering that the concept can be suitably applied in all the walks of life, I would like to start again, with the ‘Why’ of Financial Modeling.
Again, before we get into the ‘financial’ part let’s understand why we need any kind of ‘modeling’. A quick search on the internet yields this result (below).
Out of the three meanings listed above, the second meaning fits perfectly in this discussion. As rightly mentioned, we need models to devise a representation of a phenomenon or a system. E.g.
- A model of a monument would help in understanding how the monument or a building looks like from all the sides and angles which might practically be impossible or inconvenient, as you may possibly need a helicopter for obtaining the top view of the building.
- A model of a car would possibly help the designer in visualizing the final product and help in refining the design.
- A 3D model of an atom, installed in a school laboratory might be extremely useful in explaining the structure of an atom to the students. So a model helps in visualizing, imitating and hence takes us closer to understanding the reality.
So why are models required?
Models are required in two kinds of scenarios:
- When the model developer knows the reality and wants to depict it in the form of a model for others to understand
- When the model developer is trying convert his/ her own ideas/imagination into reality and wants to understand the potential outcome better (e.g. prototype)
Financial models are not too different either. The ‘why’ behind financial models is to be able to depict various real business cases to ensure that the target audience understands the potential financial outcomes/ impact and their dependency on various inputs (assumptions). The idea is to be able to simulate a real business scenario and be in situation to play with various inputs and observe the impact on outcomes. Once such relationship between inputs and outcomes is established, financial models are likely to be used to predict the most likely financial outcomes based on the probability distributions of various input parameters. The predicted outcomes are then used as one of the inputs for taking business decisions.
Let’s now look at what kind of business decisions can potentially use financial models as inputs.
Valuation of Equity
Investors who are looking to invest in a particular business can use financial models to estimate the value of the company to decide upon the price that they are willing to pay to the seller for a given stake in the company. Similarly investors who are invested in certain businesses and are looking to sell their stakes can use financial models for arriving upon the right selling price for their holdings.
- Acquisitions OR Exits by venture capitalists or private equity investors
- This is also applicable in case of IPOs/ FPOs when a company is looking to sell its stake to public. The merchant bankers appointed by the company would possibly use financial models as one of the inputs to arrive upon the right price for the IPO.
- Similarly if the individual investors are knowledgeable, skilled enough with sufficient time available to build and maintain financial models, they may take buying and selling decisions based on their own financial models
Application for and disbursement of loans
When a company is looking to borrow funds from banks or other financial institutions, the decisions about the amount to be borrowed, interest rates, period of repayment, the schedule of principle repayment are likely to be decided based on the outcomes of a financial model which would attempt to closely simulate the real business situation of the company.
Credit rating agencies issue ratings for various companies indicating the risk associated with lending funds to those companies, which is an indication for the potential lenders (buyers of bonds etc.). The credit rating agencies also revise such ratings periodically and maintain financial models for various companies.
Capital allocation decisions for internal projects
When a company is allocating capital for various internal projects, the decision makers are likely to measure and compare the financial outcomes of various projects by using financial models. Through such financial models the decision makers can better prioritize capital allocation which would help the company in meeting their financial goals.
Since various critical business decisions (as listed above and many more) need financial analysis, ability to construct financial models is an important skill.
Starting with ‘why’ is important with every aspect of life and the motivation behind any action can play an important role in deciding the outcomes of those actions. Financial models like any other models help in simulating real business situations and in predicting the potential financial outcomes of key business decisions. This makes financial modeling (if not developing, then at least understanding them) a ‘must have’ skill for business decision makers.
Happy Financial Modeling!
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