Financial Modeling Defined

Financial modeling provides a numerical view of how a business is performing, and it helps people predict how the company is likely to do in the future. It’s a broad term that can cover many different types of models. Financial modeling is used in a wide range of roles, such as internal finance teams assessing business health to make budgeting and investment decisions and by external equity analysts to decide whether to buy or sell a company’s stock or acquire or lend to a business. In general, a financial model provides a snapshot of a company's current financial situation along with a forecast of its future.

What Is Financial Modeling?

Financial modeling is the process of creating a summary of a company’s historical financial performance with the purpose of forecasting the company’s future performance. These models rely on core accounting statements—including income statements, balance sheets, and cash flow statements—combined with assumptions about future prospects, such as sales, expenses, and capital investments. A financial model combines historical performance data with predicted trends to give an estimate of future performance, such as sales, for the coming quarters or the company’s valuation.

Financial modeling helps company leaders to make informed decisions about investments, budgeting, and projects. Accurate models can help increase a company's profitability and growth by helping leaders determine the financial impact of decisions and plan for the future with a data-driven approach. They help external analysts understand the value of a business to make acquisition, investment, and lending decisions.

Key Takeaways

• Financial modeling provides a snapshot of a company’s performance and future prospects, combining historical performance data with assumptions about the future to create a forecast.
• Financial modeling is a crucial, data-driven approach in finance for decision-making, strategy, and investment analysis.
• Modeling is useful for valuing a company to decide whether to acquire or invest in the company, lend to it, partner, or make other financial commitments.

Financial Modeling Explained

Financial modeling is typically done by employees who specialize in financial planning and analysis (FP&A). Analysts using financial modeling inside a company usually work within a company’s finance department and have a solid understanding of accounting and finance principles. FP&A teams often start with the three-statement method, examining a company's current financial statements—the most recent income statement, balance sheet, and cash flow statement—as well as supporting schedules. Outside the company, analysts doing financial modeling might work at investment banks, private equity or venture capital firms, or other firms with a stake in how much a company is worth and how its future prospects look.

Analysts look at assumptions about future trends and business drivers from this foundation of financial performance data. Drivers are any factors that might significantly affect future revenue or expenses, and they can come from inside or outside the business. An example of an internal driver might be anticipated sales, manufacturing capacity, inventory, or backlog of orders—all of which will affect how much the company can sell during the next quarter. An example of an external driver might be an economic factor, such as interest rates or the unemployment rate, or a new government regulation that could slow down or speed up sales. Using these inputs, analysts can forecast the company’s financial situation in the short term (next quarter, this fiscal year) or long term (typically three to five years). Short-term forecasts tend to be more accurate than long-term forecasts because drivers and assumptions are easier to predict near term.

The goal of financial modeling is to create an informed picture of the company’s financial outlook and value, as well as the value of projects and investments. Company executives use these models to help them make decisions about where to invest, spend, acquire, divest, hire, or lay off employees. Finance leaders use models to anticipate the future value of a company's stock and market valuation. FP&A teams use models to test various scenarios, estimate the value of new projects, decide budgets, and allocate head count.

Why Is Financial Modeling Important?

Financial modeling is important because it helps company leaders make better, more data-driven decisions. By creating financial models, companies can forecast potential outcomes, identify potential risks, and adjust their strategies. Scenario planning leans heavily on financial modeling, as analysts run through assumptions and assess the possible risks and returns of decisions, such as a major capital investment like adding a new factory, hospital, or retail store location. They use modeling to make financing decisions, such as whether to pay for those big investments using debt, equity, or cash. Financial modeling is essential to making sound financial decisions that deliver long-term growth, knowing what value that growth can deliver, and understanding what risks a company is taking to achieve that growth.

What Is Financial Modeling Used for?

Financial models can provide many kinds of outputs, covering a wide range of uses. Scenario modeling in particular is widely used to help analysts run “what-if” assessments. Such assessments look at the key drivers and assumptions in a model, apply a range of values and determine the best, worst, and most likely outcomes. These models help leaders make important decisions about company strategy, such as the following:

• Securing funding. Financial modeling offers a picture of a company’s financial health and an estimate of future valuation, all of which will shape how much capital a company can raise and how much it’s going to cost.
• M&A. If a company is looking to acquire a business or is a likely target for acquisition, financial modeling is core to determining its valuation and therefore how much a potential buyer should offer and what potential sellers should accept.
• Investing in new projects. This includes expanding operations, such as opening new stores or selling in a new country.
• Allocating capital. Deciding where to spend involves determining the priority of investments. For example, the company might invest in long-term assets that depreciate over time, such as manufacturing equipment, to quickly ramp up production. Or, it could invest in assets that could appreciate over time, such as real estate for a bank branch.
• Annual budgeting and forecasting. Annual plans rely on financial modeling, often rolling up models and plans from departments throughout the company, such as sales, marketing, manufacturing, and R&D. These shape budget and headcount for the coming fiscal year.
• Providing financial guidance. During quarterly investor conference calls, a publicly traded company often will offer guidance that includes estimated revenue and earnings per share for the next quarter. Guidance can have a major effect on the company’s stock price depending on the company’s forecast and whether it hits those targets.
• Risk management. Scenario modeling helps company leaders anticipate critical risk and consider how they should respond. Financial modeling can help them understand what factors are most likely to drive existential risk for a company, such as what level of sales decrease could lead to running out of cash and having to declare bankruptcy.

Financial Modeling Benefits

A major company simply can’t operate effectively without strong financial modeling. Here are the top benefits business leaders gain.

• Risk mitigation planning: Financial modeling helps identify potential risks so that business leaders can take steps to mitigate them and respond quickly and appropriately when those risks become real.
• Identifying growth opportunities: Financial modeling helps identify opportunities for growth, so business leaders can make the right decisions about where to invest.
• Capital raising clarity: Modeling helps companies raise capital from banks or equity investors by providing a clear picture of a company’s financial situation and prospects. It also helps business leaders understand how much capital they can raise and at what cost.
• Budget and resource allocation: It helps business leaders build budgets, assign headcount to departments, and assess projects each year, allocating more budget to areas with higher ROI.
• Stakeholder financial insights: Financial modeling provides important information to shareholders and lenders, such as company valuation, future stock dividends, cash position, or quarterly revenue and earnings forecasts.

Financial Modeling Challenges

One of the biggest challenges with financial modeling is starting with accurate and complete data—even for a company’s own analysts creating models. For internal analysts, financial data is typically stored in financial software or enterprise resource planning (ERP) systems. Often, these systems aren’t connected to other software systems, such as systems to manage sales (which store revenue forecast information) or projects (where many costs are recorded). Companies might export all of this data into spreadsheets and then combine the numbers into a single sheet for modeling. This roll-up approach creates several problems, including the following:

• Manual updates required: The numbers are exported into a spreadsheet at a fixed point in time and must be manually updated on a daily, weekly, or monthly basis to maintain a model’s accuracy.
• Error-prone inputs: Working across multiple spreadsheets means the inputs are prone to human error.
• Fragile forecast formulas: The formulas used to calculate the forecasts can break across multiple spreadsheet models or users.
• Incomplete data capture: Data can be incomplete, with data hidden in operational or supply chain systems that aren't accounted for.

Other challenges with financial modeling can include:

• Biased assumptions: Overly optimistic or pessimistic assumptions about the future.
• Missing influential variables: Missing variables that should be included to influence a model.
• Unaccounted uncertainties: Failure to account for uncertainties and risks, such as a sudden increase in the cost of capital.
• Rigid model adaptability: Inflexible models that can’t be quickly adapted to sudden market changes.
• Absent scenario modeling: A lack of “what-if” scenario modeling to predict a range of possible outcomes if something goes wrong.
• Complex formula challenges: Complex mathematical formulas, such as statistical and probability distributions, that can be difficult to create, interpret, and maintain.

Financial Modeling Examples

Financial models give a snapshot of the company at a fixed point in time. These financial models can be used to value an entire company, a line of business, or even a project, such as a factory expansion or marketing campaign. Here are a few financial modeling examples.

How to Build a Financial Model

A shortcut to building a financial model is to use software that comes with multiple models and formulas built in for forecasting revenue, profitability, scenario modeling, capital expenses, and more. Planning software might also offer free-form environments that look and behave like spreadsheets but pull data from other systems in real time, so the model is always working with the latest numbers.

If you're building a financial model from scratch in a spreadsheet, the steps will change depending on the type of model. In general, however, you should include the following steps:

1. Decide the type of financial model you want to build. Many of these models will have established formulas based on accepted accounting principles, but for more complex models, you will need to create custom formulas.
2. Review the company’s financial statements and compare it to similar companies in the same industry. Consider attributes such as company history, revenue sources, capital structure, and so on. This will help you identify some of the key assumptions—such as revenue growth, total addressable market, operating costs, and profit margins—to include in your model, as well as the key risks.
3. Input historical data. To improve forecast accuracy, it’s best to include financial results from the past three years (referred to as "actuals"). This helps you map out past patterns and extrapolate those patterns into the future.
4. Calculate any financial ratios that you’ll need for your formula. These can include the company’s forecasted gross profit ratio, net profit ratio, or year-over-year growth rates, depending on what you’re trying to model.
5. Calculate your projections and forecasts. Again, these calculations will depend on what you’re trying to model. Line items, such as revenue, are generally projected using growth rates. Cost items, such as cost of goods sold (COGS), R&D, and general and administrative expenses are based on historical revenue margin (expressed as a percentage of sales). When making future assumptions for your forecasts, be sure to consider the broader trends of the market, not just your own company. Make these assumptions clear in the model, with ways to easily change those assumptions and show the range of resulting outcomes.
6. Interlink your statements. Forecasts depend heavily on accurate historical data. As new actuals come in, forecasts must be updated using.

As a more specific example, here are the steps to execute a discounted cash flow model.

• Estimate future cash flows of a business or project. Consider the factors noted above to forecast revenue, costs, margins, and market size.
• Determine the discount rate. This is usually a company’s weighted average cost of capital (WACC), since that reflects the return investors expect on their money.
• Calculate the net present value (NPV) of future cash flows by discounting based on the discount rate and when the cash flows will come in.
• Analyze by looking if the NPV is positive and whether other projects have greater NPV.

7 Best Practices for Financial Modeling

Best practices for financial modeling can vary from one industry to another, or even from one company to another. In general, here are best practices to consider when building your models.

1. Choose your model. Decide which model best meets your business need, with considerations such as a discounted cash flow, leveraged buyout, comparable company, or sensitivity model.
2. Plan and outline your model.. Decide on a timeline, the number of quarters or years you want to project, and how much historical data you need to include. Make a list of the drivers and assumptions that will affect the model; these will be different for every company and industry. A review of the most recent annual report will give you an idea of what previous finance teams considered important drivers for their business.
3. Start with accurate data. Make sure that you’re working with the most recent actuals to get the most accurate forecast. You should try to tie in plans from across departments, such as finance, human resources, sales, and operations.
4. Keep your assumptions reasonable. No one likes to deliver bad news, so there is always the temptation to be overly optimistic about the next quarter or year. Be realistic about what the company can expect to achieve considering the current market conditions, the health of the industry, and other influences.
5. Test for accuracy. Other members of the finance team should be able to understand your formulas, confirm that they make sense, reproduce the results, and agree with your general conclusions. Mistakes inevitably happen; regular peer reviews and testing will help reduce the number of errors.
6. Keep good notes. FP&A professionals move to new roles, teams, or companies all the time, handing off financial models to their successors. The next person coming in should be able to understand the model easily and reuse it for future forecasting periods.
7. Keep models flexible. Conditions can change unexpectedly, at any time, so it's important that you can quickly adjust your models to account for unforeseen events and unexpected scenarios.
8. Be transparent. A company's financial models must be shared among multiple executives and stakeholders, including those outside the finance department. They'll want to understand how you arrived at a particular conclusion. Show your work, so users of the model can challenge its assumptions. Be ready to explain your results in plain language, without falling back on complex mathematical calculations.

Build Accurate and Trusted Financial Models with Oracle Cloud

The easiest way to create and maintain financial models is to use software designed for the purpose. Software such as Oracle Cloud Enterprise Performance Management (EPM) includes hundreds of prebuilt financial models and formulas, plus a free-form, spreadsheet-like environment for more complex modeling. Oracle Cloud EPM can pull actuals from Oracle Fusion Cloud Enterprise Resource Planning (ERP) in real time, so you're always working with up-to-the-minute numbers. You select your model, input your drivers and assumptions, and get immediate results. The application easily connects to other Oracle planning software, including project plans in Oracle Cloud ERP, Oracle Cloud Sales Planning, Oracle Fusion Cloud Supply Chain Planning, and the workforce planning capabilities in Oracle Fusion Cloud Human Capital Management (HCM). These connections help give you a view of all plans across your entire business, showing how changes in one department will impact plans elsewhere in the company.

Financial Modeling FAQs

What are the four major components of financial modeling?
The four major components of financial modeling are assumptions, financial statement analysis, valuation, and sensitivity analysis. Assumptions involve making educated guesses about the future performance of a business. Financial statements include income statements, balance sheets, and cash flow statements. Valuation involves determining the worth of a business or investment. Sensitivity analysis involves testing scenarios to see how they would impact the financials of a business.

What are six types of financial models?
Six of the most commonly used financial models are discounted cash flow (DCF), comparable company analysis (CCA), leveraged buyout (LBO), sum of the parts, option pricing, and Monte Carlo simulations.

How do you do financial modeling?
The process involves gathering and analyzing data from current financial statements, identifying factors that could impact the company's future results (also called "drivers"), creating assumptions and scenarios, running the calculations, and testing the model's accuracy.