Building financial models is a key function of the financial planning and analysis (FP&A) group and provides a powerful tool for analyzing a diverse set of possible scenarios. Budget modeling is perhaps the most widely applicable form of financial modeling. The budget model allows your organization to better anticipate what’s truly important in your business. Let’s explore different examples of financial modeling and how they can help transform your corporate budgeting strategy.
The Predictive Power of Financial Modeling
Financial modeling involves the synthesis of key metrics to build a representation, or model, of a company’s current financial situation. At its core, financial modeling helps visualize the company’s current financial position and predict future performance. The process of building a financial model can be customized to analyze a wide range of business situations and questions, such as the outcome of a merger or how to price stock options.
Financial modeling is typically overseen by the FP&A group under the office of the CFO. FP&A’s role is absolutely essential to the overall health of an organization. Rigorous financial planning and analysis dictates how a company will allocate its resources and, ultimately, whether it will succeed or fail.
Financial forecasting and modeling represent key functions of FP&A. These functions provide powerful predictive insights to company leaders and serve as important decision-making tools for driving corporate budgeting strategy.
Financial Modeling Examples
There isn’t a one-size-fits-all when it comes to building financial models. Models exist in every flavor, depending on the question you’re trying to ask, and each type of model serves a unique purpose. Here are six types of financial models that are commonly used in FP&A.
1. Three-statement model
The three-statement model may be basic, but it will give you a comprehensive view of where your company stands financially. It combines your company’s three major financial statements—the balance sheet, income statement, and cash flow statement—into a dynamic model.
When done right, this model can help both internal and external stakeholders understand how financial and operational decisions affect the overall performance of your business. The three-statement model also provides a foundation on which to build more complex models.
2. DCF model
The discounted cash flow (DCF) model is a slightly more complex model that builds upon the three-statement model. The DCF model allows you to estimate the current value of an investment based on future cash flow.
DCF analysis estimates the value an investor would receive on an investment, adjusted for the time value of money—with the assumption that a dollar is worth more now than it is in the future. The investment could be anything that affects cash flow, from a potential acquisition to an internal cost-saving initiative.
3. IPO model
Before undergoing an initial public offering (IPO), a company and its investors must determine the value of the business. In the end, the value of your company will be the result of negotiations between stakeholders and represents what your investors are willing to pay. But the better you can demonstrate your company’s value through rigorous, quantitative analysis, the better prepared you’ll be for these negotiations.
An IPO model will help give you an understanding of what your business could be worth, establishing a strong foundation for discussion and showing investors that you’re aware of their concerns. IPO analysis incorporates comparable company analysis as well as an “IPO discount.” Typically, the more historical data you have to work with, the more relevant your IPO model will be.
4. Option pricing model
Option pricing models use certain variables (e.g., stock price, exercise price, interest rate, volatility) to calculate the predicted value of an option. This value is an estimate of the option’s fair value using all known inputs. There are several ways to calculate option pricing, but they’re all based solely on mathematical inputs, as opposed to subjective criteria. As a result, option pricing models are relatively straightforward to build.
5. Consolidation model
The consolidation model is used for consolidating the financial statements of majority-ownership investments. The most common application for this type of model is in the case of a company with multiple subsidiaries or divisions. A consolidated financial model combines the parent company’s revenue with the revenue of its subsidiaries or divisions to create a single, consolidated financial report. This type of model is useful for large corporations with many divisions that wish to get a full view of their operations and financial standing.
6. Budget model
The budget model is one of the most commonly used models in FP&A. Finance professionals use this type of model to generate a budget for the upcoming fiscal year. Budget models are based on a set of assumptions and historical financial data with a strong focus on the income statement.
The output of budget modeling is a set of target revenues and expenses for a given time period. This can be compared to actual profits and losses to help you better understand your company’s financials and more accurately budget in the future.
Budget Modeling to Improve Your Corporate Strategy
Certain types of financial modeling could be beneficial depending on your company’s situation—maybe management is considering pulling the trigger on an IPO or large merger this year. However, many modeling scenarios will be useful only in a narrow set of circumstances. But any company, no matter its financial situation, can benefit from budget modeling.
Building a budget model is the best way to improve your organization’s budgeting strategy. Whereas many FP&A functions deal with theoreticals and what-ifs, the budget model takes your carefully curated financial models and applies them to the real-world operations of your business. By comparing the budget model’s prediction to reality, you’ll get a better sense of what drives your business.
Budget modeling is integral to the success of a company. Yet many financial professionals still rely on labor-intensive manual processes to build complex budget models.
Excel spreadsheets can be used to draft financial models, but this approach suffers from a few major drawbacks:
- They’re static. There’s no simple way to incorporate real-time data into your Excel workbook. As a result, Excel-based models can give you only a static look at your company’s financial situation until the next time your team manually updates its financial figures.
- They’re risky. Emailing different spreadsheet versions back and forth makes it hard to ensure data integrity.
- They’re time-consuming. Creating financial models by hand takes time, especially if your CEO is interested in multiple scenario planning analyses.
However, modern software solutions offer a more connected, proactive approach to budget modeling and financial planning:
- They’re connected. Real-time data in a cloud-based system keeps everyone on your finance team and in your organization up to date.
- They’re accurate. Better data management reduces the risk of errors and gives you more confidence in your financial analysis.
- They’re automated. Automated functions save time for more important tasks.
- They’re flexible. You can create a budget model or one of the more complex, scenario-specific financial models without needing to start from scratch.
- They help you see the bigger picture. You’ll have more time to focus on high-level analysis, problem-solving, and strategizing.
Take Your Financial Modeling Further
Financial modeling is a crucial function of FP&A and assists in overall financial planning and budgeting. When done well, advanced financial modeling gives you quick answers to complex questions that can be easily shared and communicated with both internal and external stakeholders.
Are you looking to take your financial modeling further? insightsoftware’s Connected Finance solutions will accelerate your planning, consolidation, tax, and analytics. Get up and running quickly and streamline all of your financial planning tasks using Tidemark. To learn more about how you can transform your financial planning process, check out our free Continuous Planning e-book.