The Purpose of a Financial Model

Purpose of a Financial Model

A financial model can be used for a variety of professional purposes. Here just to name a few:

  1. Business Plan: A financial model is needed to prepare a business plan and obtain clarity of the expected financial situation of a company. The more solid and well substantiated the modeling logic is, the easier the business plan and its implications are understood.
  2. Scenario Analysis: Having a financial model ready for a business allows to run simulations how the financial outcome would look like when changing some of the scenario assumptions. This serves as a basis for strategy discussions and allows the management to prepare for such eventuality in time.
  3. Company Valuation: Also business plan can be used for doing a company valuation by applying the Discounted Cash Flow (DCF) method.
  4. Investment and capital allocation decisions: Within the company, capital is a scarce resource. Therefore one needs to figure out which projects are the most beneficial from a financial point of view, thus requiring financial models.
  5. Mergers & Acquisitions (M&A): A financial model forms the basis for negotiations in M&A transactions and capital increases and simulates how the company would look like when combining it with another company.

Basically, all professional investors and management teams use financial models to run their businesses. Above just to name a few of the purposes of most financial models.