Objectives of Financial Modelling

Financial modeling enables key personnel to make better decisions. These models are used for various types of decision making. Hence, one model cannot be used for all types of decision making. As a result, 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. This is the reason that they have been explained in detail below.

It is important to understand that financial modeling is not a method wherein an exact process is followed, and exact results are obtained. Instead, the reality is that financial modeling is only a framework or a set of guidelines which are used to derive numerous financial models.

There are various types of models which are created for different types of decisions. Some of the important ones have been listed below:

  1. Profitability Planning: 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.

    Profitability analysis of a firm is different from capacity planning. Capacity planning is done keeping only operational considerations in mind. However, profitability analysis and planning takes a holistic view. Usually, such models enable companies to decide on an optimal product mix which would enable maximum profitability.

    Needless to say, such models are operational in nature. Hence, their complexity is low since assumptions are being made only about the immediate future. It is not feasible to spend time in long term profitability planning. This is because it is not possible to accurately predict the variables over long periods of time.

  2. Liquidity Planning: Companies around the world take on a lot of debt. This is done to enable them to expand faster. However, with higher debt, the risk of default is also increased. If a company fails to manage its cash-flow appropriately, it stands the risk of going insolvent.

    There are financial models which enable companies to keep track of their solvency. These models take into account factors such as interest rates and currency valuations.

    The models also account for loans which may have a call option and hence may exert pressure on the finances of the firm in the short term. Companies could simulate extreme economic conditions to see whether they would continue to remain solvent if these conditions became a reality.

  3. Credit Planning: Business is mostly conducted on credit. Companies need to extend credit if they want to increase sales. However, when credit is extended, the risk of default is always present.

    Hence, corporations need to decide whether or not they are willing to extend credit to a third party. If so, the next question is how much credit are they willing to extend.

    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. The limitation of these models is that they only work if the customers publish their financials or if they are rated by credit rating agencies.

  4. Valuation of Companies: Investment banks and private equity firms also use complex financial models to arrive at a valuation for entire companies. These kinds of models are extremely complex and take several variables into account. These are the models which have been made famous by newspapers and media houses. However, very of these models are constructed in-house.

    Since there are so many variables to consider, this cannot be done with the help of a simple spreadsheet or simple programming. There are specialist software firms who create the tools required for this kind of decision making.

  5. Valuation of Financial Instruments: Lastly, there are financial models created for the valuation of complex financial instruments such as futures, options, and bonds. Such models are necessary because financial instruments have become increasingly complex nowadays.

    Also, companies need to derive their fair value automatically and on time. These financial models have become the backbone of modern technology-based trading systems. This is because firstly these models are able to quickly factor in any changes in the underlying variables and come up with a fair value in a matter of minutes.

    Secondly, this value is then fed into a trading algorithm which then buys these instruments whenever they go below the calculated fair value.

    Paying human traders is an expensive affair for many trading desks. This is because traders charge big commissions. On the other hand, financial models help automate the entire process and save on the commissions.

    Companies have been trying to build financial models which can make decisions exactly like a well-trained trader. However, they have not been able to do so until now. With the advent of machine learning and artificial intelligence, this might not be such a far-fetched dream in the future.

Hence, making an attempt to learn financial modeling is like making an attempt to learn entire finance. Wherever there is a financial decision to be made, financial modeling is possible.

Therefore, it isn’t possible to be an expert in the area of financial modeling a whole. Instead, a student would be better off choosing a particular area and then focusing their efforts.

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