Benefits of Financial Modeling
Several organizations depend on financial models for effective decision making. 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.
In this article, we discuss the top 8 benefits of using financial modeling.
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Source: Financial Modeling Benefits (wallstreetmojo.com)
#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 equity. 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 that 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 restructuring, 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, tends 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.
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