A financial model is a mathematical representation of a financial phenomenon such as a business performance or pay off of a contract that is built to help decision makers visualize such phenomenon
Financial modeling means many things to many people and is one of the grossly misunderstood subjects. For some, financial modeling is all about forecasting financial statements while for some it is all some heavy automation of financial analysis using MS Excel. But all these definitions are very narrow and is based on the limited experience of the users.
But, what is really a financial model?
Before anyone tries to understand a financial model, we should have a clear understanding of what is a model.
The term model or modeling is used in a very wide context ranging from the fashion industry to the field of pure sciences. We use models that study the spread of pandemics like Covid-19 or models that are used to study weather patterns. We even have model test papers that help prepare for exams.
So, what is common between all these seemingly different things that they are all called as models? The commonality is that all these models represent a real-world system or phenomenon. They help the user visualize and understand them without actually experience them.
So, when we are wondering how a particular dress lying on the shelf would look on us, you can look at the mannequins that is wearing them to know how it would actually look like on a human. Similarly, architects and builders make models to help potential customer visualize how an upcoming residential society would look like.
While a lot of these phenomenon are represented physically, some are more complicated. Some of those complicated phenomena, such as weather, can be visualized through images and graphs.
However, some systems are even more abstract which cannot be represented visually either. They can, however, be represented mathematically. That is where the role of mathematical model comes in. For instance, if we were to visualize the health of a business few years down the line, the only way to do that would be to show the forecasted balance sheet numbers.
Thus, financial model is a mathematical model that is used to study and represent a financial phenomenon. These phenomena could be (i) the financial position or performance of a business (ii) the outcome of a financial contract (iii) the behavior of the market and many such things.
It represents the relationship between various variables as an equation that are derived either based on logic / theory or based on observation of historical data. They equations are then processed using a decision support software such as MS Excel (or any other spreadsheet) or any other software.
Leaving out the technical terms and putting them in simple terms, we can say a financial model helps us to visualize the performance of a business or financial contract in numerical terms under various conditions.
Thus, we can use it for various purposes including the following:
(i) Corporate budgeting
(ii) Financial forecasting and projections
(iii) Asset pricing and equity valuation
(iv) Financial appraisal of projects
(v) Portfolio optimization
(vi) Risk measurement and management and
(vii) Stress testing
Although many people refer to financial modeling in the context of equity valuation, as we can see above, it has a very wide area of application.
The purpose of building a financial model is to study what could happen under certain conditions and thus take effective decisions.
For example, if a company were to consider entering a new line of business, they can build a financial model and understand how that business can perform under various scenarios. This can then help them understand the risk and reward of the business without actually getting into the business. Thus, they can take well-informed decisions on whether to get into the business or otherwise.
Building such financial models that help visualize variety of scenarios and aid effective decision-making requires thorough knowledge of various disciplines including (i) Financial mathematics (ii) Advanced MS Excel (iii) Finance and valuation theories (iv) Accounting well as (v) Strong business acumen.