Financial modeling is the process by which a firm constructs a financial representation of some, or all, aspects of the firm or given security. The model is usually characterized by performing calculations and makes recommendations based on that information. The model may also summarize particular events for the end user such as investment management returns or the Sortino ratio, or it may help estimate market direction, such as the Fed model.
BREAKING DOWN ‘Financial Modeling’
It is the goal of the analyst to accurately forecast the price or future earnings performance of a company. Numerous valuation and forecast theories exist, and financial analysts are able to test these theories by recreating business events in an interactive calculator referred to as a financial model. A financial model tries to capture all the variables in a particular event. It then quantifies the variables and creates formulas around these variables. In the end, the model provides the analyst with a mathematical depiction of particular business event. The primary software tool used to do this is the spreadsheet. Spreadsheet language allows the financial modeler to reconstruct almost any cash flow or revenue stream.
Users of Financial Models
Financial models are used for many different reasons. The most common of which are business valuation, scenario preparation for strategic planning, cost of capital calculations for corporate finance projects, capital budgeting decisions and the allocation of corporate resources. Financial models are also used in the creation of projections and trends for forecasts and many other uses related to industry comparisons, ratio analysis and common size financial statements.
Financial Modeling Example
There are myriad variables at play in the determination of a forecast or valuation. Analysts can isolate the most sensitive of these variables by creating models and then testing the model with different inputs. The inputs are then used to create a set of outputs that determine the impact of a change in one variable on another. The best financial models are simple and provide users with a set of basic assumptions. As an example, one commonly forecasted line item is sales growth. Sales growth is a function of current sales and prior quarter sales. These are the only two inputs a financial model needs to calculate sales growth. The financial modeler creates one input cell for the prior year’s sales, cell A, and one input cell for the current year sales, cell B. In the third cell, cell C, the analyst creates a formula that divides the difference between cell A and B by cell A. This is the growth formula. Cell C is a formula and hard coded into the model. Cells A and B are considered input cells for the user. The purpose of the model is to automate the calculation of sales growth.