What is a financial model?

Financial model is a mathematical model showing the likely financial outcomes of any asset, whether a portfolio of shares or the performance of an individual business. Typically, financial models examine different future economic scenarios or valuations of individual assets, whether securities, portfolios or businesses.

In short, a financial model is defined as a tool built in spreadsheet programs like MS Excel for predicting future financial performance of a company or an asset, such as a company’s share. It can also be used to assess the impact of a future decision.

Creating a financial model explained

To learn more about what a financial model means, first we take a look at the process of creating a financial model. This gives us an idea how a financial model works.

To create financial models, analysts typically use spreadsheet programs like MS Excel. To construct a useful and coherent financial model, it needs to contain the following sections:

Assumptions and drivers
Income statement
Balance sheet
Cash flow statement
Supporting schedules
Valuations
Sensitivity analysis
Charts and graphs

For a company’s financial performance forecast, analysts use historical data, future projections, and create a three-statement model, which consists of an income statement, balance sheet, cash flow statement and supporting schedules.

From this, analysts can create more complex financial models, including sensitivity analysis, leveraged buyouts, mergers and acquisitions (M&A) analysis, and discounted cash flow models.

What is a financial model used for?

As implied by the financial model definition, it is used by a company's executives or financial professionals as the foundation for any decision concerning future actions. The examples of financial model utilisation include:

Estimating the costs and the profits of a proposed new project.
Anticipating the impact of certain events on a company’s stock price.
Valuation of a business. A valuation model forecasts the company's future cash flows and then estimates how much the company would pay for the predicted cash flows.
Acquiring business and assets. A merger and acquisitions analyst creates a financial model to see whether merging two companies would result in financial performance that outperforms the results of each company separately.
Selling and divesting subsidiaries.
Budgeting and planning for the future. A financial model can be used to forecast the company’s revenue and costs as well as assess whether its performance can be improved.
Financial statement analysis/ratio analysis.
Allocating capital to determine the priority of which projects/assets to invest in.
Raising capital (from debt or equity).

Who creates financial models?

Financial models are created by various professionals and analysts in the industry to aid decision-making. Investment managers, such as hedge fund and mutual fund managers, create financial models to help them make investment decisions.

Equity analysts and researchers use valuation financial models to determine whether a stock is a buy, sell or hold. Other financial models, such as discounted cash flow analysis, can be used to determine the fair value of a stock and compare it to the stock market value. Equity analysts can recommend action on the stock based on these models.

Professionals in investment banking who work in M&A, equity and debt underwriting, credit and trading can create final models. Every banking transaction relies on a financial forecast.

FAQs

What is the use of financial models?

Financial models are used for different reasons, depending on the types of financial analysis needed. The primary use is to aid financial professionals, including company executives, fund managers and equity analysts to make future financial and investment decisions.

Who creates financial models?

Financial professionals build financial models that suit their needs. For example, an equity analyst uses valuation financial models to give a stock a ‘buy’, a ‘hold’ or a ‘sell’ rating. An investment banker who works on mergers and acquisitions can use a financial model to assess whether combining two companies can result in a better performance than the individual company separately.