Financial Modelling: Advantages and Limitations

Financial models are used by corporations almost every day. These models help while making several key strategic decisions. For instance, if a company plans to enter a new country or even take over another company, it is likely that it will create a financial model first. This model is a way of generating “What-If” information which should ideally be the part of any due diligence.

However, financial modeling isn’t perfect, either. It is not the answer to all the problems being faced by the finance department of any company. Therefore, before using financial modeling, it is imperative that a student is made aware of its pros and cons.

In this article, we will explain some of the important advantages as well as the biggest limitations which users face when they use financial models.

Advantages of Financial Modelling

Some of the major advantages of using financial models are as follows:

1. Better Understanding of the Business: Developing a financial model requires an intricate understanding of the business. The process of model creation forces the business to think about and list down the drivers which impact the various aspects of the business.

   The process also forces the business to think about the various changes that may happen internally as well as in the external environment. Hence, it would be fair to say that companies which create financial models are somehow forced to do more due diligence as compared to their counterparts. This creates a better understanding of the business. Creation of financial models, therefore, has a spillover effect which leads to a better understanding of the underlying business.

2. Helps Decide on a Funding Strategy: When companies develop financial models, they are able to clearly understand what their cash flow situation will be. The cash flow requirements that the company would face as well as the ability to borrow and make interest payments can be easily ascertained. This helps the company choose an appropriate funding strategy. For instance, start-up firms have uncertain revenues. However, their expenses are more or less fixed.

   Using financial modeling, they can decide on the amount of money that they need to have on hand in order to ensure that they survive till the revenues start flowing in. Therefore, start companies are able to ascertain the amount of equity stake they should sell so as to reach the next milestone.

3. Helps Reach the Correct Valuation: Financial modeling allows companies to understand their true worth. In the absence of modeling, the worth of a company is decided by using discounted cash flow models. Some of these models assume linear relationships between revenues and expenses, which are just not true.

   Financial models make it possible to ascertain the exact amount of free cash flow that will accrue to the firm at different points in time. This helps companies to know their exact worth when they are selling out their stakes to third party investors such as investment bankers and private equity funds.

Disadvantages of Financial Modelling

The process of financial modeling is riddled with disadvantages as well. Some of the important ones have been listed below.

1. Time-Consuming: Firstly, it is important to understand that financial modeling is a time-consuming exercise. This is because creating a financial model is a project which requires several tasks to be done.

   The data needs to collected, the underlying factors have to be identified, and the model needs to be tested for financial as well as technical irregularities. This model then needs to be made intuitive and user-friendly.

   Needless to say, all this costs a lot of time and money. Many companies, particularly smaller ones, may not have the resources to spare for this exercise. Hence, in many cases, financial models have very limited applicability.

2. Inaccurate: In many cases, financial models have proven to be woefully inadequate. The subprime mortgage crisis of 2008 is widely quoted while trying to explain this point. However, it needs to be understood that inaccuracy is built into the model itself.

   Nobody has the knowledge required to predict factors such as interest rates, tax rates, and market shares with utmost precision. If a person did have such an ability, they would make a killing by trading in the stocks and derivatives market and would not need to create financial models!

   Therefore, the numbers provided by the financial model need to be taken with a pinch of salt. If numbers are being projected far into the future, then one can be almost certain that these numbers will not be met.

3. Soft Factors Not Considered: Lastly, many mergers have failed because of soft factors such as difficulties integrating the culture of the two acquired companies. It is impossible to build such factors into financial models. On the one hand, models take into account synergies which will be created by reducing expenses as a result of the merger.

   However, on the other hand, they do not take into account the expenses which will arise due to lack of cultural compatibility. This leads to an overvaluation of assets in the long run. Many mergers have failed in the past even though the financial models had predicted that these models would be successful.

Any student of financial modeling must make an attempt to capitalize on the strengths which have been listed above. However, they also need to be mindful of the limitations of the model while making decisions based on data derived from it.