Financial models serve as a virtual representation of a business. Their main purpose is to build a reasonable proxy of the future and support informed business decisions.
The best way to assess the profitability of a company or a project is by examining the financials it is expected to produce in the future.
A financial model is a perfect vehicle that would allow us to do that.
Financial models are more than just spreadsheets with calculations. We can talk about a model when calculations are logically interrelated and there are clear relationships between the parts of the model.
Just to give you an example, if an Excel sheet multiplies a firm’s debt by the interest rate it pays and obtains the amount of interest expense it should pay at the end of the year, we can’t say this is a financial model. It is just a calculation, right?
Now, imagine the amount of outstanding debt comes from a source sheet. And, the interest expense feeds a P&L statement and a Cash Flow, which determine the debt that will be repaid, affecting the firm’s Balance Sheet. Well then, that’s the type of logical flow and reasoning we would expect to see in a financial model.
Probably, the greatest benefit of financial modeling is scenario building. It allows executives to play with a company or a project’s numbers and hypothesize different developments. They can easily see what will happen if things go south, how much cash is necessary to run the business, and when is the low point, where the firm will start burning cash.
In today’s environment, financial modeling is one of the main pillars of Corporate Finance and business decision making. It is used on Wall Street and Main street, and it pays off to be a solid modeler.