Introduction to Financial Modelling
In a nutshell, financial models are tools that replace the emotion in making financial and economic decisions with quantitative fact, leading to faster and better management decisions. Most of the time, these tools are built in Excel, which allows extensive customizations to be made easily and rapidly.
How do financial models assist with decisionmaking? They allows us to play around with various assumptions to see what the effect is on several metrics that are relevant to the decision that we’re trying to make. A good financial model will provide the user with the ability to quickly alter assumptions related to revenues and expenses, and to immediately see their impact on metrics of interest, and on the full financial statements (income statement, balance sheet and cash flow statement). A simple example where we would use a financial model is to value a company: a financial model is built that includes the drivers of sales/revenues and expense, and various assumptions relating to sales and expense growth over the upcoming years are tinkered with in order to determine a “best case”, “base case” and “worst case” for what somebody should pay for the company.
Other situations where modelling can be critical include launching a project, building a new plant, opening a new office and running a promotion on a product or service. Typical metrics that will interest end users of financial models include net profit and company/project value over time, as well as payback period.
The audience of a financial model is usually twofold: the decisionmakers within an organization, and those providing financing (investors and banks).