Financial Modeling And Why It Matters In Business

Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.

Understanding financial modeling

Many businesses make the mistake of complicating financial modeling. In truth, the only tool required is a good spreadsheet program.

Financial modeling starts by analyzing key performance metrics. In the most basic of instances, a business may simply analyze income and expenses.

More technical modeling will incorporate data from income statements, balance sheets, and supporting schedules. This data can guide future decisions on:

  • Capital raising through debt or equity.
  • Mergers and acquisitions – either of businesses or assets.
  • Budgeting and forecasting.
  • Organic growth.
  • Project capital allocation.
  • Management accounting.

Five common financial modeling templates

Many finance professionals – particularly in start-ups – will choose to create their own financial modeling spreadsheet from scratch.

However, this method assumes a not insignificant level of competency in spreadsheet data manipulation. Larger businesses will benefit from templates with intuitive layouts that handle larger calculations while minimizing the risk of data entry errors.

Here are five of the most common:

  1. Three statement model – incorporating a future income statement, balance sheet, and cash flow statement. This option gives a comprehensive overview of business financials and has the ability to accurately predict future performance.
  2. Discounted cash flow (DCF) model – the DCF model builds on the Three Statement Model to value the future cash flow of a business based on its Net Present Value (NPV). More specifically, the DCF model can be used to forecast the financials of a project, investment, or any factor that has an impact on cash flow.
  3. M&A model – otherwise known as the merger and acquisition model. A business can use the M&A model to determine whether a merger or acquisition will be financially beneficial. The model can also be used to calculate the potential earnings per share (EPS) of the resultant company.
  4. Sum-of-the-parts model – perfect for large conglomerate organizations as a means of simplifying their financial modeling. In many cases, this model is the combination of multiple DCF models.
  5. CCA model – the comparable company analysis (CCA) model works on the assumption that similar companies in an industry will have similar valuations. The CCA uses common valuation measures such as enterprise value to sales (EV/S), price to earnings (P/E), and price to sales (P/S). Using these measures, a business can determine whether it is over or undervalued when compared to its peers.

Why is financial modeling important?

Beyond the obvious implications for profit generation and bankruptcy avoidance, financial modeling also helps businesses:

  • Test the viability of new ideas or projects through feasibility proposals.
  • Attract investment capital from retail or institutional investors.
  • Track which marketing campaigns have the greatest return on investment.
  • Translate their goals and objectives into measurable figures, providing clarity in the process.
  • Identify potential cash flow problems ahead of time. This is particularly true of emerging companies where the growth rate is not sustainable financially.

Key takeaways

  • Financial modeling involves using spreadsheet software to forecast the future financial performance of a business.
  • Financial modeling can be estimated using many model templates. Some are ideal for large organizations while others are more suited to those wishing to undertake a merger or acquisition.
  • Financial modeling does more than simply help a business remain viable. It is also used to test the viability of new ideas, attract investment capital, and identity risks ahead of time.

Watch Also:

Connected Business Concepts

Accounting Equation

The accounting equation is the fundamental equation that keeps together a balance sheet. Indeed, it states that assets always equal liability plus equity. The foundation of accounting is the double-entry system which assumes that a company balance sheet can be broken down in assets, and how they get sources (either though equity/capital or liability/debt).

Balance Sheet

The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Read Next: Financial Accounting, Financial Ratios, Financial Options, Financial Structure, Cash Flows.

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