Financial modeling involves analyzing historical financials in detail and coming up with future financial projections based on certain assumptions. Therefore, financial models have become handy tools for entrepreneurs, financial analysts, investors, and business executives. So, let’s shortly recap the different ways financial models can be used for.
- Analyzing and understanding a business: Developing a financial model helps to analyze a business in a very rationale and number-focused way. Many times, financial modelers unhide the problems hidden in a company and also provide the analysis required to solve them. Financial modeling allows a rational way of looking at things free from emotion and personal attachment generally found to the business by entrepreneurs and founders.
- Making informed financial decisions: Financial models are used to substantiate and justify financial decisions rationally and transparently. They provide a tool to quantify which scenario offers the highest financial benefit to shareholders (or stakeholders).
- Valuing a business: Excel models containing a forecast of the free cash flows to firm, serve as a basis to value a business via the Discounted Cash Flow (DCF) valuation method. Future free cash flows are discounted to their present value by taking into account the risk and opportunity costs through the applied discount rate.
- Investor returns (IRR): Cash flows to investors, dividends, interest on shareholder loans, and the proceeds from their exit can be used to determine the investor return via the Internal Rate of Return (IRR). The key question investors have in mind is how much return they can make. Calculating the IRR answers this question and offers them a way to compare the investment with their other alternatives.
- Business planning: A financial model quantifies the business plan in number and comes up with the corresponding cash flow projections over the next 5 years or more. A financial model, therefore, lies at the heart of any good and meaningful business plan and goes beyond a pure next year’s budget. Many times, the term “Business Plan” actually refers to the 5-year financial projections.
- Scenario analysis: Doing business comes with risks and any business plan scenario will be subjective, representing the views of the author. For this reason, it’s important to understand the sensitivities of the model towards its assumptions and think about the worst and best-case scenario which can happen.
- Obtain the bank’s view: A bank focuses on specific financial ratios which are important in any lending scenarios. Normally, these are Debt/EBITDA ratios, Debt/Equity ratio, and debt service coverage ratios. Besides, the bank will also require some collateral to protect their downside. A financial model can project these financial ratios and therefore allow profound insights on how to best present a business plan to the bank.
- Professionalism: Spending time and effort to develop a financial model is a signal towards any investor, bank, or entrepreneur that you work professionally.
So, with this list, we hope that we were able to give you some good reasons why it’s worth to develop a financial model. If you think that we missed to point out something, please feel free to tell us by giving us a comment below.