Financial modellig

inancial modeling is the task of building an abstract representation (a model) of a

financial decision making situation.[1] This is a mathematical model designed to represent (a
simplified version of) the performance of a financial asset or a portfolio, of a business, a project,
or any other investment. Financial modeling is a general term that means different things to
different users; the reference usually relates either to accounting applications, or to quantitative
finance applications. While there has been some debate in the industry as to the nature of
financial modeling - whether it is a tradecraft, such as welding, or a science, such as metallurgy
- the task of financial modeling has been gaining acceptance and rigor over the years.
[2] Several scholarly books have been written on the topic, in addition to numerous scientific
articles.

Accounting
In corporate finance and the accounting profession (and generally in Europe [citation needed]), financial
modelling is synonymous with cash flow forecasting.[3] This usually involves the preparation of large,
detailed models, which are used for management decision making.[4] Modellers here are sometimes
referred to (tongue in cheek) as "Number crunchers".

Applications include:

 Business valuation, especially discounted cash flow, but including other valuation problems

 Capital budgeting
 Cost of capital or WACC
 Financial statement analysis
 Project finance

These models are almost always in discrete time and are usually deterministic (although see "Quantifying
uncertainty" under Corporate finance).

Although purpose built software does exist, the vast proportion of the market is spreadsheet-based [citation
needed]
 (this is largely due to the nature of the models here, as described);Microsoft Excel now has by far
the dominant position, having overtaken Lotus 1-2-3 in the 1990s.

Spreadsheet-based modelling can have its own problems [5] ("Spreadsheet Shortcomings"), and several
standardizations and "best practices" have been proposed. "Spreadsheet risk" is increasingly studied and
managed.[6].
One critique here, is that model outputs, i.e. line items, often incorporate “unrealistic implicit assumptions”
and “internal inconsistencies” [7] (for example, a forecast for growth in revenue but without corresponding
increases in working capital, fixed assets and the associated financing, may imbed unrealistic
assumptions about asset turnover, leverage and / orequity financing). What is required, but often lacking,
is that all key elements are explicitly and consistently forecasted. An extension of this is that modellers
often additionally "fail to identify crucial assumptions" relating to inputs, "and to explore what can go
wrong".[8] Here, in general, modellers "use point values and simple arithmetic instead of probability
distributions and statistical measures"[9] - i.e. the problems are treated as deterministic in nature - and
thus calculate a single value for the asset or project, but without providing information on the range,
variance and sensitivity of outcomes; [10] see "Quantifying uncertainty" under Corporate finance. Other
critiques discuss the lack of adequate spreadsheet design skills,[11] and of basic computer
programming concepts. [12] (More serious criticism, in fact, relates to the nature of budgeting itself, and
its impact on the organization.[13][14])

inancial models are often developed over the course of months and years, and many financial analysts
get caught up the grind of building, auditing and maintaining existing financial models on a daily basis,
losing the big picture of understanding best practice modeling solutions used in business and economic
decision analysis.

It is therefore useful for a good financial analyst to take a step back, examine the broad categories of
financial models that are commonly used, and determine the optimal approach for the financial and
business modeling of different scenarios and situations.

Let us first re-visit the basics, and look at how financial models can be related to its usage in modeling
an economy, industry or company.

Macroeconomic Financial Models

The models are usually econometric analysis based, built by government departments, universities or
economic consulting firms, and used to forecast the economy of a country. Macroeconomic models are
used to analyze the like effect of government policy decisions on variables such as foreign exchange
rates, interest rates, disposable income and the gross national product (GNP).

Industry Financial Models

Industry models are usually econometric based models of specific industries or economic sectors.
Industry models are often similar to macroeconomic models, and typically used by industry associations
or industry research analysts to forecast key performance indicators within the industry in question.

Corporate Financial Models

Corporate financial models are built to model the total operations of a company, and often perceived
to be critical in the strategic planning of business operations in large corporations and startup
companies alike.
Almost all corporate financial models are built in Excel, although specialized financial modeling
software are increasingly being used especially in large corporations to ensure standardization and
accuracy of multiple financial models, or to comply with spreadsheet management requirements
imposed by the Sarbanes Oxley financial reporting act.

Now that we’ve looked at the context of financial models from an economic and financial analysis
perspective, let us now examine financial models specifically from a financial modeling build
perspective. Financial models can generally be classified into 3 categories:

Deterministic Financial Models

In a deterministic model, a financial analyst enters a set of input data into a spreadsheet, programs the
spreadsheet to perform a series of mathematical calculations, and displays an output result.

Most deterministic financial models are built by performing an analysis on historical data to derive the
relationship between key forecast variables. In a corporate context, historical accounting relationships
are often used to forecast key revenue and cost variables.

Most deterministic models use one or two dimensional sensitivity analysis tables built into the model to
analyze the question of risk and uncertainty in the model’s output results. Each sensitivity analysis
table allows a financial analyst to perform a “what if” analysis on 1 or 2 variables at a time. The
advantage of sensitivity tables are its simplicity and ease of integration into existing deterministic
financial models that have already been built.

Multiple sensitivity analysis tables can be combined in a scenario manager. The scenario manager is
useful when there are interdependencies between the changing variables, as financial analysts can
configure and change multiple variables in each scenario.

In certain scenarios, multiple regression analysis is used to determine the mathematical relationship
between multiple variables in a deterministic financial model, and such analysis is termed econometric
analysis.

The deterministic model is probably the most common type of financial model used in business and
finance today. Most financial forecasting models used for revenue management, cost management and
project financing are primarily deterministic based financial models.

Simulation Based Financial Models

While a deterministic financial model is normally structured in such a way that a single point estimate
is used for each input variable, simulation based financial models work by entering the likely
distribution of key inputs defined by the mean, variance and type of distribution.

Simulation models use these range of inputs to recalculate the defined mathematical equation in the
financial model through a few hundred iterations, normally 500 or more. The results of the analysis will
produce the likely distribution of the result, therefore providing an indication of the expected range of
results instead of a single point estimate.

Where risk is a dominant factor in the financial modeling scenario being analyzed, a reliable estimation
of the likely range of results is often more useful than a single point estimate. Simulation based
financial models therefore allows a financial analyst to model the question of risk and uncertainty using
a higher level of granularity.

Specialized Financial Models

Specialized financial models are narrower in scope and essentially sophisticated calculators built to
address a specific business problem or financial computation. Cost management models, marginal
contribution analysis models and option pricing models are examples of specialized financial models.

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