What is Financial Modeling? A Comprehensive Guide

If you’re a business owner trying to make smart financial decisions for the future of your company, there’s no better tool than financial modeling.

Financial modeling involves creating a spreadsheet-based numerical representation of your company’s financial performance. Once the data is in place, it can then be analyzed to determine future performance, make assumptions and explore the impact of certain variables.

Modeling also enables you to test out different scenarios and outcomes in a risk-free environment so you can decide what steps to take next.

Let’s get into financial modeling in more detail and how you can use it to help your company make smarter, data-backed decisions.

Common Applications of Financial Models

There are many reasons why you would use a financial model. However, they’re most commonly used in four different applications:

1. Forecasting: Predicting what your future revenue, expenses and profitability might be is invaluable for financial goal setting and budgeting. It can also help you assess how to grow your business.
2. Valuation: Models assist you in determining the value of your company, assets or a specific project. This is also something investors want to see, so it’s an essential component of mergers and acquisitions (M&A) and IPO planning.
3. Scenario analysis: Simulating different outcomes of various scenarios allows you to craft strategic plans and explore risk management.
4. Capital allocation: You can use financial models to decide how and where to allocate your resources. For instance, they can tell you what the return on investment might be for a project.

Types of Financial Models

You’re likely to come across many different types of financial data modeling. Here’s a quick rundown of the main types you’ll need to know:

• Three-statement model: Incorporates the income statement, balance sheet and cash flow statement to give you an in-depth overview of your company’s financial performance. Often, this model serves as the basis for more complex modeling.
• Startup models: Focuses on projecting revenue, expenses and funding requirements for early-stage enterprises. 
• M&A models: Determines the financial impact of merging two companies together.
• Discounted cash flow (DCF): Used to calculate the present value of future cash flows to work out the value of an investment.
• Comparable company analysis (CCA): Focuses on the value of a company compared to similar publicly traded companies.
• Budget model: Helps plan your future expenses and financial activities.
• Sensitivity analysis model: Explores how changes in key assumptions can impact financial assumptions. Used for risk analysis and analyzing variables.
• Leveraged buyout model (LBO): Evaluates the returns you would get from acquiring a company using debt.
• Monte Carlo simulation: Uses random sampling to estimate the probability of various outcomes for complex scenarios.
• Option pricing model: Establishes the fair value of options based on various factors like asset price and expiration time.
• Initial public offering (IPO) model: Helps value your company if you plan to take it public.

Key Components of a Financial Model

Financial data modeling requires a lot of historical information and data, so there is a fair degree of preparation work to carry out before performing it.

The information you’ll need will differ depending on which model you’re working with, but most will typically require a combination of the following:

• Balance sheet: This commonly-used statement lists all your assets, liabilities and the equity of your business.
• Income (profit and loss) statement: Another common accounting report consisting of your revenue, cost and profits over a specific time period.
• Cash flow statement: This displays your incoming and outgoing cash from all financial activities, including business operations and investments.
• Debt schedule: This shows your company’s debt obligations (like loans and leases), when payments are due and how they impact your cash flow and leverage ratios.
• Revenue forecasts: This provides you with a forecast of revenue based on various factors, like sales growth, market trends and pricing.
• Cost structure: These are the fixed and variable costs of running your business.
• Assumptions and drivers: These are factors that affect the outcomes, like market growth rates, inflation, and interest rates.
• Valuation: This shows how much your business and its assets are worth. You’ll need this for any of the valuation-based models.

Six Steps to Build a Financial Model Scenario 

To effectively conduct financial modeling, it’s essential to adopt a meticulous and organized approach. Given that you’re working with complex data that can influence your company’s future, ensuring accuracy is crucial to avoid costly mistakes.

1. Define Your Objectives 

First, determine exactly why you want to perform the financial model. What do you want to get out of it?

Are you forecasting revenue? Planning for growth? Or something else?

Establishing clear objectives will guide you in picking the right type of financial model to use and set the foundation for the rest of the process.

2. Gather Data 

Next, you need to gather all the necessary financial data and statements. 

This includes all your company’s historical data, its current data and any other relevant information. For some models, you might need industry benchmarks or recent market trends.

Be thorough. As we mentioned, it’s easy to make a mistake, and one small piece of incorrect data can quickly result in an inaccurate, unusable financial model.

3. Structure the Model 

Now it’s time to apply all the data to a spreadsheet. Typically, this involves organizing the model into sections (inputs, calculations, outputs, etc.) and clearly defined tabs. Essentially, you’re placing everything into a format so that the data can eventually be manipulated the way you want.

Online software like QuickBooks and Xero streamlines this process, making everything a lot simpler and less time consuming for you.

4. Make Assumptions 

Once all your data has been presented in a structured format, you need to identify and apply key assumptions. These are the factors that will potentially change the outcome of your model such as growth rates, discount rates and cost increases.

Keep your assumptions realistic and simple. Avoid unnecessarily complex data that makes your model difficult to maintain and understand.

It’s best to clearly document your assumptions so they are easy to identify and adjust.

5. Build the Model 

Now that you have all your data arranged properly on the spreadsheet, it’s time to build, run and analyze your model. Use various formulas, links and references to ensure all the components are working together as intended.

6. Test and Validate

Finally, test out your model for accuracy. Run it through different scenarios and compare the results with your existing historical data.

It’s easy to overlook mistakes or errors, so the model should also be validated by a financial expert or other stakeholders within the business. 

If something is amiss, go back and retrace your steps until you spot where the error lies and fix it. Then test and validate once again.

Tools and Software for Financial Modeling 

Software makes financial modeling much easier. There are several different ways that you can build your models.

Microsoft Excel and Google Sheets

Undoubtedly, the most popular tool used for financial and investment modeling is Microsoft Excel. It’s a highly versatile program and all financial professionals know how to use it.

Excel requires a fairly steep learning curve. Even if you’re using templates, you need to have a good understanding of how complex formulas work.

Google Sheets is a cloud-based and free to use program that works similar to Excel. It’s a practical option for remote workers and for collaboration with other stakeholders.

Google Sheets is not as complex as Excel, and you’ll find it has limited functionality for very complex or large-scale financial models.

Specialized Software

Tools like Quantrix and Adaptive Insights give you the ability to perform advanced modeling at any scale. They also include features such as automation to make the job faster.

However, they are not ideal for many small business owners, as they are not cheap to use and have limited customization options.

Most accounting programs, such as QuickBooks and Xero, include financial modeling capabilities. Since they already contain all your financial data, using them can significantly cut down the preparation time and reduce the likelihood of errors.

Depending on your software’s capabilities, you may be limited to basic financial models. If you’re looking for more complex modeling functionality, you may have to integrate with other software.

Best Practices for Financial Modeling

Keep Models Simple and User-Friendly

Financial modeling is complex enough, so don’t make your model more elaborate than it needs to be. Label your data clearly, organize everything using tabs and keep the layout clean and simple. Others should be able to pick up and use your model without any trouble.

Maintain Transparency with Assumptions

Your financial model will be used among business stakeholders, so it is essential that your assumptions are transparent. 

If stakeholders can understand the assumptions, they will better grasp your financial situation and feel like they can trust you to make well-informed decisions.

Clear communication of assumptions allows stakeholders to assess the reliability of the model and see how different factors may influence its accuracy. Additionally, it’s better for effective collaboration and key for supporting audits and reviews.

Use Consistent and Logical Formatting

Adopting a logical and consistent approach to your formatting will help keep your model user-friendly. Models use vast amounts of data, so anyone looking at it needs to be able to quickly identify what they are looking for.

Use a clear, easy-to-read font, apply color coding to different data sets, and keep the formatting consistent across the entire model.

Perform Regular Updates

A model can quickly become outdated and irrelevant if you don’t update it regularly. Incorporate new data as it becomes available and continue modeling future financial decisions.

Examples of Financial Models in Action

To understand a bit more about how financial models are used, let’s take a quick look at some hypothetical examples.

Scenario 1: A startup forecasting investor returns

A startup uses the startup financial model—a detailed financial projection model—to focus on revenue growth, expenses and cash flow over a five-year period. 

By demonstrating potential ROI, this model becomes a powerful tool for attracting venture capital funding and convincing investors of the startup’s growth potential.

Scenario 2: A business planning for expansion

A retail chain employs a scenario analysis model to evaluate the feasibility of opening new store locations. 

This model takes into account market demand, expected sales growth and the capital expenditure required for construction and operational setup.

Additionally, the model assesses potential risks and returns, providing the insights needed to make decisions about expansion.

Scenario 3: Evaluating a potential acquisition

A company uses an M&A financial model to thoroughly analyze the financial impact of acquiring a competitor. 

This model incorporates projections of the combined entity’s revenues, cost savings and financing options. 

It also evaluates potential challenges and the overall profitability of the acquisition, helping stakeholders determine whether the deal will add value to the company’s portfolio.

Challenges in Financial Modeling

When developing a financial model, take care to watch out for these pitfalls:

• Unrealistic Assumptions: These lead to inaccurate forecasts and bad decision-making. Keep them based on realism and past data.
• Lack of Testing or Validation: This can result in errors and unreliable results. Validation and testing is an important step for every model.
• Incomplete Data: Keeping your finances data up-to-date, organized and accurate is key for modeling. However, many startups or newer businesses struggle with not having enough data to form a useful model. In this case, industry benchmarks can fill any gaps.
• Uncertainty: No model is 100% accurate. Financial modeling involves predicting the future, which is inherently uncertain. Creating multiple scenarios and conducting sensitivity analyses can help you plan for various potential situations.

Mastering Financial Modeling

Financial modeling is not a straightforward process and requires advanced knowledge of spreadsheets and accounting tools.

Every business owner should become well-acquainted with the various financial statements and datasets discussed earlier. Understand how to read and interpret them.

Learn more about Excel and your accounting software. Explore more about their features and functions, and practice setting up a few simple models to start getting a feel for how they work.

Financial modeling is complex. We recommend seeking feedback at every step, especially if you don’t have much experience with finance. It can also help to partner with an expert who can help you build, analyze and understand financial models.

At Finvisor we provide expert financial modeling to many different industries as well as a full range of additional financial services like accounting and bookkeeping. 

Get in touch to find out more about how we can work together to plan for your company’s future success.