What is a Financial Model?
A financial model summarises a company’s performance based on certain variables that help the business forecast future financial performance. In other words, it allows a company to see the likely financial results of a decision in quantitative terms. The measurements and skills used to construct the model include knowledge of the company’s operations, accounting, corporate finance, and Excel spreadsheets.
These models amalgamate those skills and are based on performance and then used to analyse how a business will react to different economic situations or events. These are commonly used to estimate the outcome of a specific financial decision before the company commits any funds or efforts toward it. To learn more, see our guide to financial modelling.
Types of Financial Models
A financial model considers the following mathematical representations – cash flow projections, depreciation schedules, debt service, inventory levels, rate of inflation, etc. These variables are then tested via various outputs to determine the impact of a change in one variable or another. This allows the company to quantify its decisions as to its policies, the financial obligations it makes, and the restrictions imposed by investors or lenders. A great example of a basic financial model is a cash budget.
There are various types of financial models, as outlined in more detail in our article exclusively on the subject. When asking yourself, “what is a financial model”, it is also essential to ask, “what types are there”?
3 Statement Model
This is the basic building block, the financial model. It takes the three financial statements and links them together in Excel to make a dynamically linked financial model that connects the income statement, balance sheet, and cash flow statement.
This type of financial model builds on the three-statement model described above. It takes the analysis one step further by layering on discounted cash flow (DCF) analysis to determine the business’s value. DCF models are used extensively in company valuation for mergers and acquisitions, leveraged buyouts, or business valuations.
An industry-specific model can be highly detailed and complex. It considers all the unique aspects of an industry (e.g., real estate, oil and gas, mining, financial institutions, eCommerce, etc.) and models them in Excel. This type of financial model requires a lot of industry expertise and experience, especially when making input assumptions for the business.