Financial Modelling

Financial Modelling is the process by which a firm constructs a financial representation of some, or all, aspects of a business or a security. Financial models are arrived at using Mathematical and Statistical tools to forecast and estimate financial figures. Models may range from simple Accounting models to those involving complex computer algorithms. Complex financial models require the use of computer programmes such as Excel etc.

Business owners, entrepreneurs, accountants, analysts and consultants widely make use of these models as they help in analyzing how a business will react to different economic situations or events, and in projecting the likely output of a financial decision. A Financial Model is prepared for purposes such as:

1. Valuation of a security
2. Financing projects
3. Credit analysis
4. Estimating costs of Projects
5. Analyzing cash flows
6. Evaluating Acquisition targets
7. Studying the pros and cons of mergers
8. Predict risk in investments
9. Carrying out monthly or annual financial planning
10. Conducting capital structure studies

In essence, Financial Models help reduce uncertainty and bring stability in business organisations. Investments and business projects are influenced by various internal and external factors and the history of the firm. These models based on various calculations try to take into account these various factors to make predictions for the future and help understand possible outcomes of the business decisions. They also help identify cost-effective ways to implement these decisions and find optimal solutions for the possible problems that may arise.

Some of the commonly used Financial Models are:

• Discounted Cash Flow model
• Comparative Company Analysis model
• Sum-of-the-parts model
• Leveraged Buy Out (LBO) model
• Merger & Acquisition (M&A) model
• Industry-specific financial model
• Option pricing model
• Corporate finance models

Financial Modelling has become an imperative tool for sound decision making. More and more firms today are adopting these models to minimize risks and maximize returns. Many Indian firms, however, have not familiarized themselves with the construction and adoption of financial models and is still a new, unexplored concept for them.