A financial model is a tool (typically built in Excel) that is used to forecast a business’s financial performance into the future. The forecast is typically based on the company’s historical performance, assumptions about the future, and requires preparing the income statement, balance sheet, cash flow statement, and supporting schedules (known as a 3 statement model). From there, more advanced types of financial models might be built such as discounted cash flow analysis (DCF model), leveraged-buyout (LBO), mergers and acquisitions (M&A), and sensitivity analysis, among others.
In a financial model, input variables are used to calculate output variables. These variables can be anything from sales volume and price per unit to operating costs, tax rates, and capital expenditures. Changing the input values will affect the output results, which can then be used to explore a range of different scenarios in terms of financial outcomes.
Financial models are used for many different purposes. They are often used in business valuation to determine the attractiveness of an investment opportunity. They’re also used in strategic planning to forecast the impact of various business decisions, such as a major capital expenditure, a new product launch, or a corporate acquisition or merger.
In short, financial modeling is a key tool used by businesses and financial analysts to predict the financial outcomes of various scenarios, assist in decision-making, and communicate financial information in a summarized manner.
Example of a Financial Model
Let’s consider a simple example of a financial model for a hypothetical startup company, let’s say, “ABC Technology Co.” The company is in its early stage, developing a new kind of software product.
- Revenue Forecast: ABC Technology expects to sell its software product at $100 per unit. They project that they will sell 1,000 units in the first year, and due to an expected increase in demand, they expect sales volume to grow by 20% each year for the next 5 years.
- Cost Forecast: The company has fixed costs (like office rent, utilities, etc.) of $50,000 per year. Additionally, the variable cost per unit of the software (cost directly associated with producing one unit of the software) is $20.
- Profit Calculation: Based on these revenue and cost assumptions, ABC Technology can calculate its projected profits for each year over the next 5 years.
This is a very simplified example of a financial model. The real-world financial models would include much more detail, including separate line items for different revenue streams and costs, calculations for interest, tax, depreciation, amortization, detailed balance sheet, and cash flow statement, etc.
Also, sensitivity analysis can be performed to understand how the change in key variables like unit price, growth rate, and cost per unit will impact the profits.
The purpose of such a financial model is to help ABC Technology plan its business, secure funding if needed, and make decisions such as pricing, production volume, and capital investments, etc. It provides a kind of “what-if” analysis that helps to prepare for different scenarios and make informed business decisions.