A financial model serves the purpose of interpreting financial numbers into a meaningful analysis. While they vary depending on the objective, the information gathered from financial models allows for quality decision making, a better understanding, and a simplified story of a real world financial reality. 

We’ll go over some common characteristics of these tools as well as some examples. 

 

Meaning and Objective

Constructing a synopsis of financial information involves calculations & gathering meaning from them. Doing this across different industries and companies involves different nuances. 

A couple objectives can be:

• Cost Savings
• Budget & Forecasting
• Company Growth
• Revenue, Income, and Profit
• Cash Flow & Operations

 

With some basic assumptions and historical data you can gather a lot of useful information that can be used in decision making. The more informed decision is usually a better one, and provides insight for owners, shareholders, and investors.

 

Points to Know about Financial Models

 

Historical Results and Assumptions

Good historical information provides for better assumptions. The more detailed, the more realistic a financial model can be. 

For instance knowing the amount of sales you had each month for the last couple of years can help predict how much we should see this coming year. 

 

Income Statement and Balance Sheet

This income statement shows a company’s income and expenditures. This statement is key to viewing the financial health of a company. This statement also contains a lot of important data that can be used in your model.

 

A balance sheet contains a company’s assets and liabilities at a given time. This is another key financial tool that can determine the health of a business. You can use the data from this document in your financial model as well. 

 

Supporting Schedules

Both the income statement and balance sheet provide great information that you can use for a financial model. Depending on your objective however you may need to grab more specific details of information. 

Supporting schedules provide more detailed information, usually used to build and create the income statement and balance sheets. Usually in the form of a table this information can provide greater insight and specifics to use for your model. 

 

Build the Cash Flow Statement

A cash flow statement of a company demonstrates an organization’s total inflow and outflow in terms of cash and cash equivalents.

What cash flow demonstrates is a company’s ability to meet liquidity needs, ensuring it can make payments, continue operations, and sustain itself.

The information you gather from a cash flow statement can be used in your financial model, where you can specifically mention incoming cash, or expenses that have yet to be paid. 

 

Perform the Discounted Cash Flow (DCF) Analysis

A DCF analysis shows the present value of expected future cash flows using a discount rate. This analysis helps see the potential future value of a business, based on historical data, assumptions, and/or other market indicators. 

This analysis is important because it works with assumptions, and these assumptions can be applied in our financial model along with the other metrics you’ve discovered. 

 

Add Analysis and Scenarios

After you have gathered a lot of useful information about the business or company you are analyzing you can start building out your model. 

Ensure to use clear titles and methods, so anyone viewing it can see how the analysis is being made. 

Scenarios are mice to incorporate since you depict multiple analysis based on varying assumptions. This is useful when assumptions need to be changed, or market indicators depict other metrics to use. Scenarios can also provide different perspectives on the same set of assumptions and analysis with varying degrees of correction. 

 

Build Charts and Graphs

A good model makes sure to utilize visual aids. Visual aids not only provide an easier to understand grasp of the analysis, but can also help highlight errors or differences. Getting a totally new perspective on a set of data points can uncover things that may have been lost in the numbers. 

For instance, a line graph that depicts the trend can better highlight the direction the trend is going. You may even discover some outliers that may be skewing it in one direction or the other.

 

Test and Update the Model

Models are tools that companies use to make informed decisions, and to make the most informed decision you have to ensure that you are continuously improving or updating your model.

This means updating assumptions, industry metrics, whatever it is that can ensure your model reflects an accurate analysis. 

Make sure to test your model as well, to ensure it can handle all types of scenarios and always provides an accurate representation of said scenario. Don’t be afraid to improve your model as well, the more accurate a model is the better analysis you can uncover with it. 

 

Financial models take on all types of shapes and sizes, with so many different applications these tools are great to know how to work with and more especially create. I’ll go over the different types of financial models and how to best use them soon.