Financial Modeling Benefits

Article byNiti Gupta
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Are Financial Modeling Benefits?

The financial modeling benefits are on the continuous rise due to the ever-changing financial landscape across sectors and the overall economy of any country. There is a threat of various types of risks and also the urge to make considerable returns from investments, where these models play a huge role.

Financial Modeling Benefits

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Several organizations depend on financial models for effective decision-making. One can use historical data and current market scenarios to forecast future economic performances. These calculations help in designing strategies to mitigate risk and achieve financial objectives. The use of financial modeling toolsFinancial Modeling ToolsFinancial modeling tools are the set of information or skills or any other factor elements that helps an analyst evaluate the value of a company, a business segment or a project's viability.read more and techniques is increasing, considering its overall benefits.

Financial Modeling Benefits Explained

In the current economic environment, the financial modelling benefits play a very important role. The process involves creation of a summary of data in a very organized format which can be interpreted easily by its users. Such data is partly collected from past historical transactions and performances and partly calculated using various different formula.

They are used for forcasting future financial performances based off which the stakeholders can make important decisions regarding investment and growth potential of a business. The models are typically made in the form of spreadsheets, where financial data is entered to calculate projected revenue, expense, profits losses and so on.

The models help in understanding the impact of different financial transaction on different areas of the business. This in turn helps to analyse whether the strategies implemented in the business to carry out operational process in departments have given positive results over a time period or some changes are required to initiate the required objective.

These models act as a guide to analyse the stock performance which affect executive decisions in the long run. It is possible to estimate the value of business and compare it with its peer companies to identify areas of high performance and areas that require immediate attention.

Overall, in this articles we will study the innumerable benefits of the process in details so that we are able to use it in the best way possible for making financial decisions both as stakeholders and as management.

Benefits

In this article, we discuss the top 8 benefits of using financial modeling.

#1 – Improved and in-Depth Understanding of a Business

A financial modelFinancial ModelFinancial modeling refers to the use of excel-based models to reflect a company's projected financial performance. Such models represent the financial situation by taking into account risks and future assumptions, which are critical for making significant decisions in the future, such as raising capital or valuing a business, and interpreting their impact.read more is developed after having a deep insight into the business. The analysts understand how a business operates and what are the different factors that could impact such business. The businesses are also required to understand what changes are expected to take place in a scenario when there are changes in the internal as well as external environment of the business. Thus, companies which develop financial models can understand their business as well as the factors affecting them better than their competitors and are therefore better prepared for any uncertain situation.

#2 – Periodic Review of Performance

To understand how a business is performing, it is important to do the variance analysisVariance AnalysisVariance analysis is the process of identifying and analyzing the difference between the standard numbers that a company expects to accomplish and the actual numbers that they achieve, in order to help the firm analyze positive or negative consequences.read more. Financial models help in carrying out the variance analysis by comparing the actual results of the business against the budgets. The performance review can be done periodically to get feedback on the business operations. Some advanced financial models help the businesses to carry out adjustments in their operations based on the variance analysis so that overall profits can be improved.

#3 – Decide the Fund Requirement & Strategy

Financial models provide clarity on the expected cash inflows and outflows. A business can get to know the net cash flows that it would be required to arrange to run its affairs. The next step is to decide the source of funding, i.e. debt vs equityDebt Vs EquityDebt refers to the source of money raised from loans on which the interest is required to be paid. Thus it is a form of becoming creditors of lenders, whereas equity means raising money by issuing shares of a company. Shareholders get returns on such shares from the company's profit in the form of dividends.read more. For this, the financial models help in understanding what would be the cash flow position after meeting the interest expense and repayment of loans. This helps to decide whether and to what extent the business can take debt and what shall be the level of equity financingEquity FinancingEquity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule.read more.

#4 – Business Valuation

Companies that wish to know their worth can use financial models. A financial model helps in determining free cash flowsFree Cash FlowsThe cash flow to the firm or equity after paying off all debts and commitments is referred to as free cash flow (FCF). It measures how much cash a firm makes after deducting its needed working capital and capital expenditures (CAPEX).read more tthat are expected to accrue to a business at different points of time which further helps in reaching the fair value of a business. This becomes useful for businesses when making any restructuringRestructuringRestructuring is defined as actions an organization takes when facing difficulties due to wrong management decisions or changes in demographic conditions. Therefore, tries to align its business with the current profitable trend by a) restructuring its finances by debt issuance/closures, issuance of new equities, selling assets, or b) organizational restructuring, which includes shifting locations, layoffs, etc.read more, such as when selling the stake to the outsider parties and investors.

#5 – Risk Minimization

Since a financial model helps in carrying out due diligence by suggesting the financial impact of a particular activity, thus, it helps the businesses in minimizing the overall risk in a business. For example, suppose a business wants to enter the new market; a financial model would guide the business regarding the cost of such entrance, the effect of marketing, price changes, and so on.

#6 – Financial Models Generate Quick Outputs

Businesses may take months to get answers to certain financial questions and to determine the impact of a certain decision. However, financial models are quick in giving results which helps in quick decision-making. In such a way, financial models become very useful for businesses.

#7 – Much Accurate Financial Budgets and Forecasts

Financial models build financial budgets and forecasts based on business data and thus, tend to be accurate. Businesses can use these budgets and forecasts for their business activities so that their activities remain structured and within the defined structure. Not following any budget or business strategy can be harmful to the businesses.

#8 – Helps in Business Growth

How the financial models help a business to grow is by suggesting the areas that are capable of generating higher profits. The models also help in carrying out a cost-benefit analysis of new projects. Businesses can use financial models to understand as investment shall be made in which areas and projects for better profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more and growth.

Example

Let us take an example to understand the concept.

We assume ABC Ltd is a pharmaceutical company which operates within a country and plans to open offices outside the country too, in order to expand. The business is in the market for past 5 years and have performed reasonably well inspite of strict competition due to its quality of products, innumerable branches and online presence, which facilitates customers to order and get delivery instantly.

However, it is necessary for the management to decide whether it is feasible to invest in expansion at this stage and if so, then how much funding is required to make it happen. They decide to use their past data to project future performances regarding, sales, revenue, cost and profitability and then decide of the same after detailed assessment of its asset and liability positions.

In such a case, financial modelling is a very useful tool, as it will suggest the way forward through calculation to evaluate the estimated cost of the process and projected profits that the business may expect. They ca also use the model to anticipate the effect of various external events on its existing strategies and frame budgets in advance. This will help in planned financial approach during expansion phase.

This the above example explains the benefits and importance of these financial models in a company.

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