What is Financial Modelling?

Planning is the cornerstone around which business empires are built. Businesses which survive and thrive in the long run are often businesses which have diligently kept track of their external environment and continued to plan ahead. In many ways, planning is intuitive to human beings.

Every salaried individual plan how they are going to pay the bill every month. Every housewife plans how they are going to source the various products required for household consumption in the most cost-effective manner. This household planning is often easily accomplished with the help of the back of the envelope calculations.

Planning done by large businesses is also similar in many ways. The only difference is that the number of variables which impact large businesses is much larger.

For instance, large businesses have to take into account the impact of price changes in several markets, possible changes in taxation policies, increase or decrease in consumer demand, and many more things. Therefore, simple back of the envelope calculations which suffice for household needs are not sufficient for these companies.

Instead, these companies require a complex mathematical model where the effect of several variables can be considered. Simply put, a financial model is nothing but a more advanced form of calculation which helps companies plan and make appropriate financial decisions. These decisions then enable them to increase their profit margins, market share, or meet other pre-determined business goals.

The defining feature of financial modeling is that it is forward-looking. Financial statements like Balance Sheet and Income Statements are considered to be financial models if they created for a future date based on certain underlying assumptions.

Definition of Financial Modelling

As mentioned above, the world modeling refers to complex mathematical calculations. Financial models, therefore, refer to the creation of abstract representations of a company’s financial statements. The idea behind the creation of these models is that decision-makers can simulate their decisions and finally see the impact on the company’s finances.

A financial model allows a company to simulate their revenues and expenses under various situations. This is the reason why financial models are extensively used when companies are about to make big decisions like launching a new product line, entering a new market, or acquiring a competitor.

Approaches to Financial Modelling

There are two common approaches which are used during financial modeling. Both of them have their own advantages and disadvantages. The exact approach is chosen depending upon the budget and technical sophistication of the company undertaking the process. The two approaches have been explained in detail in the article below:

1. Top-down Approach: The top-down approach takes an external approach to financial modeling. This means that the approach begins by considering the market as a whole. The financial modeler has to then begin by making an educated guess about how the macro-market is likely to shape up in the near future. For instance, the percentage of growth, the barriers to entry, etc. are considered to be the starting point for the financial model.

   Once the size and characteristics of the market are ascertained, the firm tries to determine its position vis-a-vis the competition. Finally, the sales, revenues, and expense figures and derived based on these calculations. The strengths and shortcomings of the company are viewed in the light of the macro-market.

   Since this approach to financial modeling pays a lot of attention to external variables, the numbers derived from this model are often very accurate. Also, this model works very well for companies on a budget. This is because volumes of point of sales data are not required to make this model work. Also, this approach forces firms to view the trends in the entire market. This helps them better appraise the long term profitability potential of the firm given the external environment.

2. Bottoms-Up Approach: The bottom-up approach is the exact opposite of the top-down approach. This approach begins by analyzing internal variables such as the product or service being offered. Based on these internal variables, operational planning is done, which allows the determination of department-wise budget and production capacity. The bottoms-up analysis works better for companies which operate in a stable market where the external conditions are unlikely to change drastically over a short period of time.

   Bottoms up approach provides a forecast on a line by line basis. As a result, businesses are able to decide on their product mix and align their resources internally. Also, the data in the bottoms-up approach is collected by lower-level employees who have a better understanding of the process. Hence, if there are any discrepancies or wrong assumptions being made in the planning process, they are brought to the fore and corrected immediately.

   However, many companies cannot afford the bottoms-up approach since it means that the point of sales data needs to be collated and analyzed. This is what makes it an expensive proposition.

Hence, it would be fair to say that financial modeling refers to a wide variety of tasks and methods which are used for planning by companies depending upon their own capabilities and financial position. It would also be fair to say that financial modeling is the cornerstone of diligent decision making and hence, is extensively used by businesses today.