What Is Financial Modeling? Here’s a Closer Look

When you are first starting a business, how and when you use your finances can be crucial to the lifeblood of your business. According to the United States Bureau of Labor Statistics, about 20% of small businesses fail in their first year. That is why it is immensely important to get financial support from the start. 

At GenCap, Alexander Dillon focuses on supporting growing businesses with capital and leadership. One crucial aspect to look at is your financial model. Read on for an explanation of financial modeling and a closer look at how a sound financial model can benefit your business.

What Is Financial Modeling?

A financial model is a quantifiable way to examine a summary of the expenses and earnings of a business. Often in the form of a spreadsheet, a financial model can be used for a variety of reasons, most often to see how a future event or decision will impact the company’s bottom line. Financial models are used in a variety of settings to look at things like:

• Risk management
• Company valuation
• Asset valuation
• Acquisitions and mergers
• Raising capital
• Option pricing
• Budgeting and forecasting
• Allocation of capital

From this short list, it is easy to see how many ways a good financial model can help a business. Financial models are also used by financial analysts to evaluate and predict stock performance based on a variety of variables.

Learn More About How to Understand Financial Modeling

Financial modeling means looking at numbers. What kind of numbers? By looking at the past, present and possible future of a company, financial models help business owners and executives to make informed financial decisions. Are you thinking of expanding your company? A financial model may be beneficial to look at the costs and benefits of expansion. 

Not a business owner? Financiers, including investment bankers and data analysts, often use financial models to either understand or anticipate how events will impact or have impacted stock and company valuation. Changes in stock valuation can come from both internal and external forces — anything from changes in business strategy or management to external forces like changes in laws or regulations that affect a business. 

Financial models are also helpful when it comes time to estimate the value of a business or to compare the value of one business to another within the same industry. 

What Is Financial Modeling Used For?

A financial model helps individuals on the inside or outside of business make decisions. Whether a financial model is used to try to raise capital, increase the size of a business, sell a business, budget for the future or value a business, a financial model can be a valuable resource. 

Examples of Financial Models

There is no one-size-fits-all financial model for every scenario. Take a look at a few types of financial models to see how they could benefit your company. It will likely depend on what you are trying to forecast. 

Discounted Cash Flow Model

A popular method of valuation in the finance world, the discounted cash flow model determines the value of a company by looking at the net present value as the sum of future cash flow discounted to the present value. The “discounting factor” is typically determined by looking at the weighted average cost of capital.

The discounted cash flow model helps to determine how accurate the value of a stock is for a particular company.

Sensitivity Analysis Model

A sensitivity analysis model is helpful in predicting what will happen to a company under a set of conditions. For example, a specific set of independent variables can impact the overall performance of a company quite dramatically. A perfect example is thinking about how the cost of raw materials can cause changes in the finished goods or services offered to customers and how that has to be communicated to your customer base. 

Three Statement Financial Model

In the traditional three-statement model, accounting looks at the income statement, balance sheet and cash flow statement to analyze the relationship between the three. By looking at profitability, assets, resources and liabilities, you can get an accurate picture of the financial health of an organization and make predictions for the future. 

What Information Should Be Included in a Financial Model?

The best financial models contain a lot of information. Graphs, charts and numbers accompany items like income statements, balance sheets and cash flow statements, along with schedules, valuations and more. 

What Types of Businesses Benefit From the Use of Financial Modeling?

There are a wide variety of businesses that benefit from the use of financial modeling. Bankers are an obvious group, especially those involved in trading and sales. Bankers and investment professionals use financial modeling to justify sales and purchases of stock, predict future trends and make recommendations to clients.

Likewise, accountants also use financial modeling. In the accounting world, financial models can assist in audits as well as due diligence investigations and valuations.

How Do You Know a Financial Model Is Accurate?

When it comes to financial models, accuracy is imperative. Mistakes and errors can be expensive. Sometimes, financial models are validated by outside sources in order to ensure accuracy. 

When you are trying to make accurate predictions for the future health of a company, you need to know that your financial model is accurate and reliable. Don’t hesitate to seek third-party validation when time and money are on the line. Research indicates that inaccurate financial reporting costs United States businesses nearly $8 billion a year. 

Alexander Dillon serves as President and Managing Partner at the New York-based GenCap Management, a venture capital/private equity firm focused on deploying capital into public and private companies with high growth potential. 

From a degree at the University of Maryland to a skilled entrepreneur and investor, Dillon truly loves what he does, utilizing his expertise in private equity, investing and financial modeling to support startups and empower success in all manner of businesses. He is also a frequent volunteer at several local charities and opened a restaurant in 2021 with two of his childhood friends.

Written by Alexander Dillon.
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