What is a financial model?
Financial models are important tools for management and shareholders to gain valuable insights into the current and future performance of a business. They use inputs and assumptions to calculate financial outputs like statements and metrics. These outputs empower management to make better and more informed decisions around planning and operations.
Financial models can be can be as simple as calculating a debt schedule or as complex as a fully-integrated three statement forecast with multinational business units.
More than an Excel spreadsheet
Financial models are often thought of as simply being spreadsheets. However not all spreadsheets are financial models and not all financial models are spreadsheets. The key distinction between the two is a spreadsheet only presents existing information while a financial model actually creates new information.
For example, an Excel workbook with international stock prices converted to a single currency using historical exchange rates is only a spreadsheet. While it does include calculations, it is only presenting existing information in a different format. However if the spreadsheet is also used to calculate a portfolio value based on those stock prices and inputted share holdings, it would become a financial model.
Example types of financial modelling
The following are a few different types of financial models which can be developed for any business.
- Long-term forecasting – project the performance of a business over a long-term period based on growth assumptions and key business decisions.
- Cash flow – calculate the future cash balance based on known and assumed cash in and outflows from operating, investing and financing activities.
- Valuation – value a business or project based on one or more methodology including Discounted Cash Flows (DCF) / Net Present Value (NPV), earnings multiples, or book value.
- Project evaluation – assess and compare project delivery options, either as a stand-alone entity or as a part of the larger business.
- Transactional & funding – evaluate the impact on a business based on proposed merger and acquisition (M&A) transactions or debt and equity funding arrangements.
- Pricing – determine the price of one or more goods and services based on projected input costs, sales volumes and required profit margins.
- Portfolio management – optimise asset holdings based on risk preferences and performance.
What does a good financial model look like?
Not all financial models are created equal. The following are elements which all good financial models should adhere to regardless of type or complexity.
- Robustness – models should be built in such a way to minimise the chance of an error occurring in the first place. However if an error does occur, the model should make the error obvious to any user of the model. This is generally done through reconciliations and checks with multiple redundancies.
- Efficiency – a model should always calculate the required outputs using the fewest inputs and calculations as possible. Inputs should only need to be entered once and calculations only performed once. This reduces the chance of mistakes creeping into a model through unnecessary complications and duplications.
- Transparency – if a user with a reasonable understanding of the assumptions cannot understand a financial model, their confidence in the model will diminish, thereby increasing risk of the model being used ineffectively. It should never be acceptable to say “only the model owner understands how that model works”.
- Scenarios – a key feature of all financial models is the ability to determine an outcome based on assumptions which may change, it is critical these variables can be tested. This should be done to determine the impact if key assumptions are different from the most likely case.
How do your models stack up?
Pilot can assist you in developing and implementing financial models for your business or project. For more information, please contact Thomas Paul from our Corporate Advisory division on (07) 3023 1300.