“The best financial models are simple enough for anyone to understand, yet dynamic enough to handle complex situations.” – Tim Vipond.
In our previous article, we have established how important business finance is to guide you to make shrewd and prudent quantitative decisions. It is necessary for you to have knowledge on this to start, run and expand your business.
Financial modeling enables leaders to make various types of decisions. One model cannot be used for all types of decision making reason why several different types of models have to be created. Each of these models’ requires different inputs and provides different outputs. A good financial modeler should be aware of the basics of these different types of models.
In order to effectively communicate and systematically analyze financial statements for improved model performance, Duncan will be covering styles, formatting, layout, error capturing and other technical issues to be considered.
Some of the Financial Statement Analysis he will cover will be helpful in plannning:
Profitability - The most obvious use of financial modeling is to optimize the day to day operations of a firm. This type of models is used by companies to ascertain how they can deploy their resources in the most profitable manner.
Liquidity - Companies around the world take on debts to help them expand faster. They have to be able to manage cashflow and track their solvency
Credit - Business is mostly conducted on credit. There are financial models which help companies make this decision. Such models take in information from credit rating agencies and the publicly declared financials of their customers to decide how much credit should be extended to them.
Financial models are used by corporations almost every day. These models help while making several key strategic decisions. Here are some of the advantages and limittions of Financial Modelling which most will be address in our upcoming courses.
Advantages of Financial Modelling
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. T
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.
Helps Reach the Correct Valuation: Financial modeling allows companies to understand their true worth. 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
Time-Consuming 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
Inaccurate In many cases, financial models have proven to be woefully inadequate. Nobody has the knowledge required to predict factors such as interest rates, tax rates, and market shares with utmost precision. Therefore, the numbers provided by the financial model need to be taken with a pinch of salt.
Resources:
Management Study Guide on Financial Modelling
Basic Financial Modelling and Intermediate Financial Modelling courses by Duncan Williamson