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Financial modeling is a term widely used but rarely understood as a whole. Everyone just knows that it is “important for business,” but a few know what makes a financial model and what are its characteristics. A financial model would be an ongoing process that a company develops in order to make sure that the financial resources match the financial plan or model. The main features include various calculations at different stages and estimates which give a clearer vision of how to allocate the finances. A financial model can also include a rough estimate for end-clients and give them guidelines regarding their budget.
A financial model can be developed from bottom to top, but it can also build upon an existing financial model which may need an update or maintenance.
Types of Financial Models
They can be quite simple or indeed complex. All that depends on how much someone relies on modeling. A financial model refers to any calculation or prediction that refers to any kind of financing. A simple financial model can be developed by any individual, while complex financial structures usually involve computer programs taking up to few hours before they can be accessed.
One of these complex models is the Value-at-Risk model which is often the choice of risk managers since it enables a coherent display of the state of play. Discounted Cash Flow is another financial model that is used to assess the profits an investor gets from his investment.
Financial modeling means to use experience and statistics to make an abstract calculation that reflects the real-life situation. This term is strictly bound to accounting, corporations’ finances, and quantitative applications. It includes taking into account the risks, the potential profits and losses to make forecasts of future financial movements. It requires a great deal of research, analytical and technical analyses, as well as knowledge of the particular market. An efficiently constructed financial model has the power to mitigate the risk factors that a company could possibly be faced with in the future.
Attention to detail is very important, given that financial models should be free of human error, and that is why many financial experts rely on computerized systems to get it right. Sometimes, it is just too much for the human brain.
How to Avoid Mistakes?
The financial model needs first of all to have a goal it needs to achieve. Whether it concerns a new product and the subsequent marketing campaign or debt service, its purpose has to be clearly defined. Another important target bullet point is to define the user, is it an investor, banker, manager, etc.
As we said, statistics is important, so an accurate financial model plan might require ready-available financial statements which can serve as a valuable source of information. These financial statements might take some time to be prepared by the supervisors since they include different aspects like balance sheets, leverage and liquidity status, cash flow statement, estimates of investors’ profits, etc. Many underestimate the importance of cash flow statements whereby they present viable and efficient data. The data usually include estimates on borrowing needs, as well as return on investment assessment.
The Design and Organization
When you work in a company, then the company probably has their own forms and norms on how they construct their financial models. Make sure to comply with the company's inner rules, as well as to deny access to unauthorized persons. Protect the data and enable their update if need be. Also, if your supervisors require it, write an additional summary. Make sure to arrange the files properly so that they can be automatically searched.