Financial modeling is a process through which a mathematical or statistical model is established and used to determine the behavior of a company within a specific market. It is an essential factor in strategic planning to ensure the efficiency of a business.

Financial modeling can be of great help to financial analysts, investors or any type of entrepreneur, whether experienced or in their initial stages of entrepreneurship.

How is financial modeling built?

Broadly speaking, financial modeling is built on historical data and niche studies. In addition to assessing performance and providing summaries of past results, it is also used to predict the likely future performance of a business.

Some basic data to take into account when defining a financial model are:

History of financial statements for the last few years (showing clear information regarding current debts, assets, income, projected expenses, etc.).
Current inventory status (goods, products and services).
Analysis of the positioning within the industry to which the business belongs.

What types of financial modeling are there?

There is no single way to set up financial modeling. This will depend on the type of issues you want to verify, evaluate or the specific precautions you want to take. Of course, although there are a number of the most common options within the field of finance, a wide variety of numerical representations can be constructed depending on the needs of each case.

The first thing you need to do to decide is to have a clear objective. Are you trying to value a company or predict its behavior, its risks, etc.? This will help you focus your financial modeling.

If you want to know what the top 5 types of financial models are, learn about them below. Some will fit well as a financial model for startups and others will be more suitable for businesses with several years of track record and extensive experience.

1. Financial valuation modeling

This type of model is used to estimate the fair value of a financial asset. It can be one or several stocks, an investment option or bonds. These models are based on the assumption that the price of an asset reflects its underlying values (asset values quoted daily in the market).

To build a valuation model it is necessary to take into account all the variables. Knowledge of the Weighted Average Cost of Capital (WACC) will be very helpful. Consider the following points or model alternatives to guide you in this regard:

Merger model (M&A)
Discounted free cash flow approach (DCF model)
Price-earnings (P/E) model

2. Financial risk model

There are many types of risks that a business may face. For example: credit risk, liquidity risk, market risk, etc. This will always be linked to interest rate fluctuation, market instability and other types of events that can happen unexpectedly.

To work on this, a finance specialist must have knowledge of the CAPM model (Capital Asset Pricing Model), of concepts such as VAR (Value at Risk); and must take into account all possible risks according to the type of business involved, the expectations and the current reality of the company.

3. Forecasting models

To know where your company stands with respect to its chances of progressing or, on the contrary, going bankrupt, you must concentrate on formulating to predict. There are two types of analysis that are made in this context:

Complete study of the company's financial conditions
Study of the market in which the company operates.

A conjunction of all this data, converted to numerical representations, will be referred to as predictive financial modeling. Of course, there is no fixed value as everything in this area is constantly changing, so everything is based on probabilities.

4. Simulation models

This type of model is used when you want to evaluate the possible impact that the business would have in different scenarios. As you know, the market fluctuates constantly, it is not a fixed phenomenon. In addition, there could also be internal transformations such as:

Internationalization of the business
Outsourcing (i.e. the company resorts to external suppliers to offer certain types of new or highly specialized products or services to its customers)
Transfer
Reorganization of human resources (from boards of directors to the most recent employees)
Incorporation of new products and services
Abandonment of a line of products or services that were previously offered

Therefore, you have to know how to move through the spectrum and have solutions for each situation.

5. Financial modeling for optimization

If your goal is to find the most profitable financial strategy or set of options available to drive your company's growth, you will most likely need a model known as an optimization model.

Through this tool, the most optimal combination of assets for an investment portfolio is found, for example, always taking into account risks and returns.

Tips for a successful financial model

It is important to keep several things in mind to avoid complications and inconveniences with financial modeling.

Data sources: you must ensure that you have quality and up-to-date data. In addition to being reliable, it must also be relevant to the purpose of the financial modeling. Having the wrong data can lead to ineffective modeling; in the long run, this could be dangerous for the stability of the company.
Accuracy and sensitivity: on the other hand, the model must be sensitive to data changes that may eventually occur. It must also be accurate and have a good predictive capability.
Simplicity: keeping it simple is another essential factor. It is functional to have a simple model in case it needs to be passed on to other workers, or to be interpreted and used by people who are not financial specialists but who are interested in looking at the business information; for example, potential investors.

In this regard, we suggest using different types of graphics that make it easier to read. A pitch deck can be a great idea to organize this type of information.

Verification: after having worked to achieve a financial model, an important step is to check that it is working properly. Tests and comparisons can be made with sufficient data and over a period of time to analyze the results and the reality of the company.

Finally, don't forget that this type of model must be restructured regularly so that it is no longer accurate and useful.

If you have any questions or require a personalized consulting session, do not hesitate to contact our team. We can attend you remotely to avoid the difficulties of mobility and the time investment of your agenda.

What is financial modeling and what types are there?