Financial modeling is one of the main factors in investor decision-making , indicating the value of the company and whether it is aligned with its current market value.
This means that it is an important tool, as it allows you to simulate different investment scenarios in the short and long term.
With financial modeling, it is possible to evaluate the financial impacts of choices and support strategic decisions. It is a fundamental practice for analyzing options and achieving favorable results.
Its main objective is to help you make decisions before taking a new step in your business, from opening a new branch to investing in a new product.
What is financial modeling?
Financial modeling is used to show the company’s potential and attract investors with a good growth projection, influencing decision-making.
It is a concept used to anticipate the performance of a financial asset over a specific period and in various possible situations. In addition to companies, it can also be applied to investments in shares, applications and personal finances.
This idea is the result of a series of methods. It serves as a mathematical model that compares one or more hypothetical scenarios with the real situation.
Financial modeling includes the Balance Sheet , Income Statement (IS) and Cash Flow Statement (CFS).
What is its importance?
This is an essential resource for good business management . This is because the use of financial tools is essential to ensure good performance and good results , helping the manager to make the best choices based on real data, avoiding putting the company’s assets at risk.
With financial modeling, the entrepreneur also acquires arguments that help him attract investors, showing what the impact of his investment would be on the business in a given period of time and what performance can be expected with the expansion and profitability estimates that the company will achieve from this financial contribution.
In this way, financial modeling serves to decide what the next steps for the business will be, in addition to showing the value of the company and its potential in the market and, also, raising resources and investments.
Financial modeling also serves to:
- Evaluate the organization and functioning of the company, comparing scenarios;
- Manage risks, studying what is worth doing or not;
- Decide whether a change would be advantageous or not;
- Find out whether a strategy or investment would remain sustainable in the medium and long term;
- Define capital allocation;
- Price the company’s shares if it goes public on the stock exchange (Initial Public Offering — IPO process);
- Comparison of assets, such as shares traded on the stock exchange;
- Analyze the performance of different actions;
- Decide whether it is worth acquiring a business or entering into a partnership;
- Know how to expand the company’s scope of operations (opening new stores, mergers, acquisitions, investment in other markets and regions, etc.);
- Make the budget forecast;
- Compare companies in the same sector;
- Assess whether the projected scenario is consistent and sustainable.
Financial modeling example
Integrated financial projections ( balance sheet, income statement and financial statements) are the most important tools in building a company’s financial model.
It is a common misconception that this kind of business budget analysis is only appropriate for small and medium-sized business owners.
After all, by avoiding risks and conquering challenges, financial modeling assists the business in deciding on its next course of action for safer and more sustainable growth.
With its forecasts, it is a fundamental financial management tool that also helps to make an accurate diagnosis of the company, understanding its market value and supporting the search for investors and even in dealing with banks to renegotiate debts. For this reason, it is used in strategic and budgetary planning processes.
How to build an efficient financial model?
Balance Sheet, Income Statement (IS) and Cash Flow Statement (CFS) reports are necessary for integrated and effective financial modeling.
First, then, it is necessary to gather business data and history with these three demonstrative reports.
This will allow you to analyze revenue growth, the financial cycle, operating margins and capital expenditures. Then, you need to study external variables , such as competition and inflation, and determine the assumptions that will guide the projection of the financial statements.
The most common order is to start with the DRE, with the projection normally starting with the forecast of revenues and expenses (administrative expenses, taxes, etc.).
Then comes the balance sheet, a record of all the assets and obligations of a company in a given period that shows how the resources (or assets) are applied and what their sources are (liabilities and equity).
Balance sheet variations are driven by the DRE’s operational assumptions (inventory, taxes, labor), which reinforces the importance of developing integrated models, uniting these reports.
Finally, there is the DFC projection, also integrated into the first two reports and considering operational activities, investment activities and financing activities.
What are the best tools and techniques for financial modeling?
Financial modeling can be done using specialized software or spreadsheets (such as Excel). The advantage of spreadsheets is that they can be customized. On the other hand, software offers more practicality and the possibility of performing more complex analyses.
Financial modeling must be integrated, combining the three reporting statements (DRE, balance sheet and DFC). This way, the model becomes more complete and allows the application of variables, so that the performance projection of each part of the company can be seen in a more informed way.
To ensure greater consolidated information, the use of appropriate tools is essential — and fortunately, there is now an increasing supply of specialized programs. Spreadsheets are very accessible, but they can be lacking in terms of data integration and reports, and are less reliable.
In addition to offering software for integrated reports, there is currently also an offer of specialization courses in the area.