Everything You Need to Know about Financial Modeling

In today’s turbulent business landscape, businesses must use all available tools to avoid failures and ensure success. One of those tools is called financial modeling which is used to forecast the future financial performance of a company based on its historical performance and other factors. Afterwards, companies can use this knowledge to create strategies and plans for further actions with a minimal risk of failure. At first glance, all of this may sound too complicated to comprehend, so let us try to “break down” financial modeling in order to represent it in a more understandable and clear manner.

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The Job of a Financial Analyst

The first question that comes to mind is “What does financial analyst actually do?” Well, it is a combination of numerous tasks and analysis which lead to the main goal – an accurate forecast of future earnings and performance of a company. Before reaching this goal, an analyst performs numerous valuations, and applies and tests various forecast theories. When examining particular events, an analyst must capture all the variables of a specific event, quantify them and create formulas around them. Finally, the results show the analyst a mathematical depiction of the mentioned business event.

The Best Tools for the Job

Microsoft Excel spreadsheets are usually used for building financial models, but there are various other software solutions dedicated to this matter. Some of them offer simplified processes and a more structured alternative to Excel driven implementations. The features they can and should offer are “what if” scenarios, forecasting, audit trial, balance sheet, consolidation, chasm management, profit/loss statement, general ledger, income statement and multi-department.

The Types of Financial Modeling

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There is a vast range of financial models used by companies based on their current needs. So, to choose the right model, a company must know what answers it is searching for. Here are some of the models and their applications in short.

  • A leveraged buyout is used by investment firms and sponsors to determine whether they can afford such a large investment and get enough return.
  • Discounted cash flow is used across all sectors to evaluate the potential of an investment based on free cash flow and discounts.
  • An option pricing model is meant to compute the theoretical value of an option at certain time.
  • A sum of the parts model determines the value of different company’s divisions.
  • A merger and acquisition model presents the impact of the acquisition to earnings.
  • A comparative company analysis model is used by investment banks; it compares similar companies against each other.

Uses of Financial Modeling

Different types of financial modeling exist because there are different uses of its techniques and results. The most common application of this tool is business valuation, but it is often used in scenario preparation for strategic planning, capital budgeting decisions, cost of capital calculations for corporate finance projects and the allocation of corporate resources.  Furthermore, financial models are used in predicting the trends and many other fields related to industry comparisons, financial statements and ration analysis.

Prerequisites for Financial Modeling

The basic prerequisite for financial modeling is knowledge of Excel (interface and tools, frequently used formulas, techniques and importing and handling data) or another software solution used for this purpose. It is also important to know valuation techniques, corporate accounting and finance. Modeling itself is a skill of simplifying complex things without losing their essence. Being such a complex discipline, financial modeling isn’t an area where every company has skilful experts. Fortunately, there are many firms offering litigation support services, thus providing various scenarios, assessments, analysis and advice.

It is obvious that financial modeling is a tool which can bring a unique set of benefits to every company in a business world where insecurity is the biggest error that can be made. Knowing that, there are no excuses not to use it, whether with the resources a company already has, or by looking beyond the company’s walls.

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