Financial modelling is essential for every business, and today with the pandemic’s impact on businesses of all sizes, clear, concise financial modelling is more important than ever.
This article will outline what financial modelling is, what financial modelling is used for, the benefits of financial modelling, and some of the standard financial models used.
What is financial modelling?
Financial modelling is the process of building a model to forecast and predict how a business may perform in the future. In small and large companies alike, financial models are often made using Microsoft excel/spreadsheet software or other financial modelling software to link a company’s financial statements with formulas. These predict the business’s financial performance over a certain period based on certain assumptions.
These assumptions can be changed to see what effect different circumstances would have on future growth. While all companies can benefit from financial modelling, small businesses that traditionally don’t have huge profit margins rely on financial modelling to get solid interpretations of how their business may look in the future.
From a commercial perspective, financial models are also beneficial for financial analysts who use these models to predict how a company’s stock performance might be affected by executive/business decisions and future events.
What are financial models used for?
Inside a company, financial models are typically used by executives and decision-makers to make decisions about:
- Raising capital and funding
- Making acquisitions, for example, businesses or assets
- Growing a business organically, e.g. opening new locations, entering new markets, building new products
- Valuing a business
- Budgeting and forecasting
- Financial statement analysis
- Management accounting
What are the benefits of financial modelling?
As we’ve already explained, financial modelling is essential to assessing the business’s future performance and identifying any potential events or risks that could affect the company in the future. These areas can be broken down into more concrete benefits:
Scaling your business – A successful financial model gives you deep insights into the different factors affecting your business’s performance. Some of these factors will be able to point and uncover potential areas of growth.
For example, if, as part of the analysis, you discover that you’re not spending much on advertising through a particular channel and you think investing in this channel could bring you more leads and customers, then you can prioritise that particular advertising channel moving forward to test out your hypothesis.
Reducing churn/losing customers – Conducting a deep analysis into your business can uncover how you’re losing customers and identify potential churn risks that could affect your business moving forward. Many companies focus solely on growth. While this isn’t inherently wrong, identifying reasons and factors causing your business to lose customers can help you put measures in place to reduce churn and improve customer retention.
Business valuation – If you’re looking to determine how much your business is worth, a financial model can help you achieve this. As part of the analysis of your model, you’ll find out how much revenue you’re bringing in and how much income you’re losing and gain some clarity into your business’s valuation.
Minimising risks – A financial model can help you identify and lower the financial risks your business could face. For example, a financial model will help you identify the costs of your marketing campaigns, the cost of entering into a new market, any changes in stock valuations and more.
Clear assessments – Every company will have quarterly or yearly plans, projections and budgets for how they think their business will perform. A financial model can help give you insights into how your business is performing and compare your business’s performance and your existing plans, predictions, and budgets.
Methods of conducting financial modelling
There are many different types of financial modelling, and unfortunately, we can’t cover them all in this article. But three of the most common methods are:
#1 The three statement model
The three statement model is the most simple form of financial modelling. The model uses three statements: income statements, balance sheet and cash flow. These are all linked with formulas in Excel, and the objective is to set the model up so all the accounts connected and a set of assumptions can drive changes in the entire model. Three statement models are a foundational model that allows for more advanced financial models to be built upon.
#2 Discounted Cash Flow Model (DCF)
The DCF model is a little more advanced than the three statement model and is used to value a company based on the Net Present Value (NPV) of a business’s future cash flow. This model does this by taking the cash flows from the three statement model, makes adjustments where necessary and then uses the XPNV function within Excel to discount the cash flow back to the current day at the company’s Weighted Average Cost of Capital (WACC).
#3 Merger Model (M&A)
A merger model consists of combining the financial statements of the buyer and the seller in an acquisition. The model is used to reflect the effects of the acquisition, such as interest paid on new debt and any new shares that have been issued. The complexity in merger models can vary greatly, and this model is commonly used in corporate development and investment banking.
This article should have given you some insights into the benefits that financial modelling can bring to your business and some of the common types of financial modelling used. While creating a financial model can be done in-house, professional services can help you make an in-depth, comprehensive financial model for your business.