What would you give to have a crystal ball? To know what the future holds for your business, your market, your customers and your finances? To mitigate your risks by understanding what’s likely to happen to your company in the long and short term? Of course, no such instrument exists. But financial modelling provides companies with the next best thing. It uses mathematical data captured in the present to anticipate what the future is likely to bring.
Financial modelling is a useful and versatile tool that can benefit businesses of all kinds. Here we’ll look at how it works, how it’s used and what kind of models are commonly used in business.
What is financial modelling?
Simply put, a financial model generates a representation of a company’s finances in the present in order to forecast its future performance. It typically takes the form of a spreadsheet in Microsoft Excel or an equivalent.
Wherever decisions are made to buy, sell, grow or start a business, you’ll find financial models in use.
When is financial modelling used?
There are lots of circumstances under which financial models will be built and employed. They may be used by entrepreneurs to determine the viability of their business idea in their chosen market. They are often employed as part of the due diligence process when deciding whether to acquire or merge with a competitor.
They are also often used to keep shareholders informed and give them a clear snapshot of the state of their investment. Sometimes models are developed by internal teams, while other times they are carried out by third parties such as equity research firms.
Common instances where financial modelling may be used include:
When acquiring businesses or assets
Growing a business by entering new markets or locations
Deciding where to allocate capital allocation
Budgeting and forecasting
Valuing a business
Carrying out financial statement analysis
What data is used for financial modelling?
Different kinds of financial models require slightly different data used to achieve slightly different outcomes. However, there are certain types of data that commonly feature in financial models. These include:
Income statements or and balance sheet
Cash flow statements / discounted cash flow (DCF) analysis
Historical figures and assumptions
Models are also usually stress-tested and audited to ensure they are fit for purpose in different scenarios or under different circumstances.
What are the different kinds of financial models?
There are dozens of different types of financial models. However, they broadly fall into these categories:
Project finance models
Whenever you embark on a new project, you need to know if the potential rewards outweigh the potential risks. Projects may include a new startup, a new product line or branching into a new location or market. Project finance models can help to determine a project's viability.
Merger and buyout models
Extensive modelling is necessary to determine the benefits and risks associated with buying out or merging with another company. M&A / merger models, leveraged buyout (LBO) models and consolidation models are used to help companies to make informed decisions about mergers and acquisitions.
Reporting / integrated financial statement models
These “three-way” financial models incorporate three kinds of statements into an integrated model:
Cash flow statement
Profit & loss statement
These are used to get a clear picture of the company’s finances.
The pricing of a product or service is crucial to its selling proposition and profitability. As such, financial models are often used to identify revenue and profit for new and existing products.
We can help
If you’re interested in finding out more about financial modelling and applying it to your business finances, then get in touch with our financial experts. Find out how GoCardless can help you with ad hoc payments or recurring payments.