“Measure twice, cut once.” It’s an old, analogue saying, but rings true in today’s fast-moving digital world. When an influencer tweet can affect stock prices or the slightest misstep can draw the ire of internet trolls, companies need to meticulously vet strategic decisions.
Wouldn’t it be nice if you could explore scenarios in a safe environment to explore opportunities and anticipate problems before they even happen? Fortunately, businesses have an abundance of data to tap into for these insights to build simulation models. Scenario planning or simulations can help virtually every branch of your business, but none more so than the finance department.
What is a simulation model in finance?
In finance, a simulation model is a method for creating a conceptual financial mockup, which consists of a set of mathematical formulas and interrelations that replicate the company's responses to scale. These models enable flexible and integrated simulations of different company scenarios, such as sales volume simulations and their effects on revenue, inventory to calculate anticipated EBTIDA and cash flow.
This activity aids in visualizing a company's current financial situation and forecasting future financial performance. Financial modeling is useful in a variety of scenarios. It can aid in the making of investment decisions, the pricing of securities, and the planning of corporate transactions such as mergers, acquisitions, and divestitures.
Day to day, financial simulation models are used to help executives make key business decisions. Rather than making a judgment call and hoping for the best, executives today have the benefit of tech-savvy financial professionals who can run multiple simulations to predict the choice with the best outcome. This capability gives companies a huge competitive edge.
Types of financial simulation models
There are many different kinds of financial simulation models, each of which has different purposes. Financial modeling should begin with a goal – whether it be to understand how a decision will affect the business, determine if the future looks bright, or pursue any other business objective.
Three-statement financial model
The ****three-statement financial model simulates future projections of the three financial statements – the income statement, balance sheet, and cash-flow statement. By simulating multiple situations and analyzing the three-statement financial model, companies can predict how different choices or events will impact the business overall.
The merger and acquisition (M&A) model shows the potential earnings per share to be gained by combining two companies. This value can then be compared to the current earnings per share of the company. The M&A model can help a company determine whether or not a potential merger or acquisition is a good decision.
This simple forecasting model uses prior data to predict future growth. Using a simulation model, you can test how different performances would affect future growth. For example, you might run a what-if scenario examining how much revenue the business would bring in if it continually grows at 3% each year.
Moving area model
Companies utilize a moving area model to measure performance on a monthly basis using the moving average approach. It’s similar to the straight-line model, but on a more frequent basis.
Linear regression model
A linear regression is a more generic financial model that can be used to compare two variables. For example, a linear regression could be used to demonstrate how changing the consumer cost of a product impacts revenue. This is a particularly useful calculation because of its flexibility.
Discounted cash flow model
The DCF model is used to generate a valuation, either of the company as a whole, a project, or anything else that impacts cash flow.
Capital budgeting model
Many companies dread creating an annual budget. However, maintaining a capital budgeting model and using it to simulate various scenarios reduces the burden. The net present value (NPV), internal rate of return (IRR), and payback time calculations will virtually always be used in this financial analysis and modeling.
There are many more financial simulations companies use based on their needs. The right financial model will depend on the questions your company executives need answers to and the current situation. Building simulation models in a traditional spreadsheet leads to lengthy calculations and manual data entry. But, data platforms like Causal help financial advisors get straight to analysis thanks to built-in templates and premade what-if scenario programs. Regardless, simulation models are a great way to predict future possibilities and deliver insights that are valuable to the company at large.
Benefits of building simulation models
Simulation models allow executives to evaluate the overall business situation and make more informed decisions. However, that’s just the beginning of the benefits. Simulation models help companies plan better, pursue growth opportunities, and understand how the business operates.
By using financial simulation models, companies can plan better by anticipating possible outcomes. They can predict issues before they arise and mitigate the problem. For example, if the finance department runs a linear regression and uncovers that a new product is losing money, the product team can adjust accordingly before significant losses are incurred.
Additionally, simulation models can be used to pursue growth opportunities. Whether a company is seeking funding, looking to infuse more capital with a loan, or pursuing a partnership, using a financial simulation model to show growth potential can be incredibly convincing. Talk is cheap, but numbers don’t lie.
Overall, financial simulation models are an important way for companies to understand how they operate. They can see how any variable is impacting the business, explore scenarios before making a decision, and see how elements are changing in real-time.
It’s important to know that simulation models can have drawbacks. They can be labor-intensive if done manually. They are also prone to mistakes, so it’s important to check your work and reevaluate any results that are surprising. The mortgage crisis of 2008 is one example of financial modeling used irresponsibly. Financial models should not be used to justify extremely risky decisions. All decisions should be carefully evaluated by experts and supplemented by models.
Financial simulation models are used every day by successful businesses, so what are you waiting for? With Causal’s free plan, you can hop right into the scenarios and simulations to explore opportunities without rolling the dice.