Companies use financial modelling to check assumptions and forecasts. These financial models can extrapolate data to assess what scenario might result from changing one or more variables. Typically created within spreadsheets, companies can build financial models on which all manner of business judgements can be based.
What is Financial Modelling?
Financial modelling is a form of financial forecasting. It’s a tool that takes historical and forecast data and applies a set of assumptions to it. These variables can be changed and tweaked – together or singularly – to view the likely outcomes. Each scenario can be compared to check for favourability, and the necessary changes that will bring about those results can then be implemented by the company. Assumptions used can include sales volumes, prices, expenditure, margin and so on.
Financial models are most often created in spreadsheets – typically Excel, which is the world’s most used spreadsheet software. They can be created to analyse different scenarios. Some are very complex and have many inputs and variables. Others are simple and may track just one key figure.
Some companies integrate their spreadsheet models with other software that optimises the process. NetSuite, for example, comes with integrated financial planning functionality that has a powerful modelling tool. It collects your prior data to create a predictive model. It can even incorporate industry benchmark data and with just a few clicks can generate a dashboard that displays your key modelled figures and forecasts.
Why Use Financial Modelling?
Using a model is the simplest way that you can predict how a certain factor might affect the future performance of your company. It can be used to create different scenarios – each with varying factors – and then used as a basis for decision-making in the company. Models help you to evaluate the risks of instigating certain changes.
They can also be useful in preparing financial statements for potential investors, banks or insurance providers. With the relevant modelled projections, you can confidently pitch for funding or a loan, for example.
Ultimately, a financial model can help you more clearly see where your business is at right now, and where it could be in the future.
Examples of Financial Models
There are many different types of financial models. Here are some that are commonly used:
- The three statement model takes your profit and loss (P&L), balance sheet and cash flow statement and links them into a model on which many other models can be built. It takes your assumptions and models the effects on each of these three central aspects of your finances.
- A mergers and acquisition model combines the financial information from two companies, so that the valuation of the joint entity can be presented.
- An IPO model uses a number of inputs to value a company before it goes public.
- If you are seeking investment, you might build models that show the growth that your company is projecting as a result of that investment. This would also demonstrate the return that those investors might see.
- A budget model can be used to project internal expenditure, with variables based on the number of locations and staff, capital expenditure, marketing spend and so on.
- Finally, financial models can project how changes to your pricing, or your distribution strategy, or your headcount will affect cash flow or revenue or profit.
Best Practice in Financial Modelling
Within finance, there are some accepted norms when it comes to building and customising financial models. These best practices result in financial models that are flexible to being adapted, are easy to understand and which aid business decision-making. Here’s what you should be sure to take into consideration:
- Ensure you understand the problem at hand, who will use the model and what you aim to achieve with it.
- Try to build the model within single worksheet, to avoid errors and improve how it is understood.
- To make your spreadsheet clearer to read, gather your data into logical sections. First bring all your assumptions together, then add in your balance sheet and P&L account.
- Use a standard colour-coding or formatting convention. For example, clearly distinguishing data that comes as an input by formatting the font colour and also the cell fill or border style.
- Keep number formats consistent. For example, throughout your models, use the same formatting for negative numbers, stick to the same number of decimal places, and use the same currency symbols.
- Each value should appear in its own cell and not be repeated elsewhere. This helps prevent errors and maintains your model’s clarity and readability.
- Don’t embed your assumptions into formulas in case you forget where they are when you come to make adjustment. Instead, keep the assumptions separate and label them clearly.
- Try to ensure the formulas you use are simple by breaking them down into separate calculations where possible.
- Double check all your figures and formulas. Your model’s accuracy depends on you building a quality tool.
- Finally, put your model to the by building and assessing a number of different scenarios. Testing these to see if the model fails allows you correct errors and refine the model before you properly use it.
Financial Planning and Budgeting Resources
Here are two practical resources to help you put your financial planning and modelling into practice:
- This webinar recording introduces and explains the capabilities of NetSuite’s planning and budgeting tool. It increases forecasting accuracy by 12%, reduces planning times by 38% and optimises management reports creation by 32%.
- This ebook, High Impact Planning and Budgeting for All Types of Growth, explains an approach to planning and budgeting for midmarket companies looking to grow
Dynamic financial modelling using these best practices can greatly assist with calculating future predictions. Financial models help companies to identify the improvements they can make to their business, as well as secure funding and loans. They make goal-setting easier and ensure companies have the right data on which to base business-critical decisions.
If you would like to know more about using an ERP system that has built-in financial modelling functionality, and which seamlessly incorporates your financial data to create complex spreadsheet models, let us show you what NetSuite can do. Book an appointment now or contact us today.