What is financial modeling?

What is Financial Modeling? At its core, financial modeling is really just a business form of what we call a model. So what is a model? Well it's really a simplified representation of reality. A map is a great example of this. If you think about what a map does, it helps us to simplify reality. It tells us how to get from point A to point B, and only focuses on the details we worry about or care about, like what streets to take to get to our destination. We avoid all of the unimportant details that we don't care about. Things like what tress or buildings are along the way, or what other cars might be around, things like that. If we had to represent the full complexity of reality, including trees and buildings, the map would be much more difficult to read. 

A financial model does exactly the same thing. Every major company decision is decided based on how much the outcome of that decision is worth. Firms need a way to figure out how to make those decisions based on the reality of the world without all the gory detail that's unnecessary, and that's where financial modeling comes in. Financial Modeling involves assessing a future level of cash flows for a particular business or project, and then the risks around those cash flows. We put these things together, we take our current cash flows in reality, what we project them to be in the future, and then we value those based on the risks to the business. That's what a financial model does at its core. In particular, when we get done, our financial model should help us to summarize a number of different factors from reality into a single output that we care about. The particular output might vary depending on the model or the business, but it could be something like net present value, or internal rate of return. It might be the value per share for a company that we're considering buying, or for our own company. It might be an internal metric, like debt service coverage. Whatever that metric is, the financial model helps us to get there. In particular, the financial model lets us focus on the key issues and risks. Just like the map helps us go from point A to point B, a financial model lets us take our business from our starting point to our intended destination, without having to worry about unimportant details along the way. 

Now a good financial model then needs to have three characteristics. Number one, needs to be simple, but not so simple as to artificially distort reality. Number two, it really needs to focus on the key cash flow drivers for the business. What are the key factors that drive the business forward? These need to be captured in the model so that decision makers understand them. And then third and finally, it needs to convey the assumptions and conclusions that business decision makers care about. If we're gonna assume that revenues will grow at 5% on an annual basis going forward, our financial model needs to make that clear. There's nothing wrong with making those assumptions as long as they're clearly identified for managers and business decision makers. In particular, a good financial model should help us to evaluate risks around a business decision. We can use a variety of techniques to evaluate those risks: Sensitivity analysis, break-even analysis, scenario analysis, and more. The financial model helps us to understand the risks and complexities of the business decision that we're making. 

There's a variety of alternatives to a traditional financial model. For example, business decision makers often rely on gut feeling or back of the envelope calculations. These are a great sanity check for a financial model, but they're not a substitute. Smart business decision makers know that financial models are an important starting point for most decisions. The financial models that we use can be either deterministic or stochastic. Deterministic models set assumptions and then compute financial ratios and cash flows based on those assumptions. We can also use stochastic models. These are really involving a lot more probability theory. We won't talk about those as much in this course, and they're more complex to implement in reality, so they're not as widely used. A couple of important notes here: First of all, you can't model what you don't understand. For that reason, we're making the assumption that you understand something about finance. If you need a refresher or maybe help with the basics, I recommend two courses here on linked and learn: Excel for Corporate Finance Professions, and Excel for Management Accounting. Each of these will give you the background that you need to be able to succeed with financial modeling going forward.