If you're in charge of a set of finances, it's in your interests to know how how those finances are likely to change over time:
- Will you need to raise capital?
- What will your liquidity look like over the next 12 months?
- Can you make a certain capital expenditure today?
These are the sorts of questions that financial modelling helps to answer.
What is financial modeling?
Financial modeling is the process of forecasting a company's finances into future months and years, in order to make decisions about that company.
A financial model will typically start off with a set of inputs that reflect the current state of a company's finances. It then adds some assumptions which are relevant to how the company's finances are likely to change over time.
Some examples of these sorts of assumptions are:
- Revenue growth rate
- Future capital expenditures
- Depreciation of assets
The financial model takes these assumptions in conjunction with the current financial state of the company, and projects the company's finances forward.
A financial model will also often feature scenarios. Scenarios allow you to look at how the future finances of a company are impacted by a change in initial conditions, or a change in the assumptions about how a company grows over time.
For example, you might want to look at how a company's future financial situation changes depending on its revenue growth rate. To do this you'd create a model with scenarios for each growth rate that you wanted to look at.
Once you've put all of these elements together into a model, the model can then be used to inform decisions about the company. These decisions might be about whether it's a company worth investing in, or how much capital it'll need to raise in the coming years.
What does financial modelling apply to?
In the section above, we've looked at financial modelling as it applies to a company's finances. In truth though, financial modelling is much broader than this.
In addition to businesses, you can make financial models that apply to assets, stocks, or even people, if you wanted to forecast your own finances for example.
To keep things simple, let's focus on financial modelling as it applies to a company's finances. Pretty much everything in this article though can be applied just as well to any of the other types of financial models out there.
What are some examples of financial modelling?
There are plenty of different types of financial models, which all try to answer different financial questions in different ways.
Some of the most popular are:
Cash Flow Modelling
A cash flow models is arguably the most common type of financial model, and the one that most people are familiar with.
Cash flow models try to answer the question what will a company's cash levels look like at various points in the future.
Answering this question is vitally important to businesses, as cash is the oxygen that businesses rely on. To see why, let's imagine you run a manufacturing business.
You won't just need cash to pay your operating expenses (your rent, utilities, insurance et cetera), but also to buy raw materials. These raw materials get manufactured into products, which you then sell on to generate more cash.
Put simply, you need to cash in order to generate more cash. Cash flow modeling refers to any financial model which helps you to forecast your cash balances forward, so you can ensure your business always has adequate levels of cash.
Almost every business needs to produce cash flow statements as part of their financial statements. Interested in learning more about the concept of cash flow? Take a look at our beginner's guide to financial statements.
Discounted Cash Flow (DCF) Modelling
DCF modelling is a way of answering the question: what is the fair price of a company?
It begins by taking estimates of a company's cashflows over the next several years. A discounting rate is then applied progressively against these cashflow projections, to account for the opportunity cost of having capital tied up in an investment.
For example, let's say you're deciding the fair price for a particular company.
If you could get a 4% return on investment elsewhere, you might discount that company's cashflows by 4% in the first year, by 8.16% (4% compounded twice) in year 2, and so on.
Once you've applied this approach to all of the company's cash flow projections, you'll arrive at an estimate for the fair price of the company. This could help you to make decisions about whether to acquire the company, or whether to buy shares in it.
DCFs models aren't just a cool toy; they're used everyday by investors and traders to make real-world financial decisions.
Who can benefit from financial modeling?
Financial modeling is all about helping you to make better decisions about companies. In that sense, anyone who has to make decisions of this sort can benefit from building financial models.
This could be because you're:
- A business owner, who needs to understand how decisions made today will affect the future of their company.
- An investor, who wants to forecast the future returns of an investment in a particular company.
What's the best way to build a financial model?
If you're looking to build a financial model yourself, you've got a number of different options.
One of the most common ways of building a financial model is to use a spreadsheet app, like Google Sheets or Excel.
Spreadsheet apps can be good because they're used frequently in most professions, but they do come with a number of downsides. Some of these are that:
- They don't scale well with model complexity: As your model gets more complex, spreadsheets can become exponentially more difficult to make changes to.
- They don't account for uncertainty: Spreadsheet models typically assume you know exactly how the future will unfold. The sorts of things that will affect a company's future finances are often highly uncertain, and spreadsheet models aren't able to account for this.
- They make scenario analysis difficult: If you want to run scenario analysis (or what-if analysis) on a typical spreadsheet model, you'll have to recreate the model for each scenario that you want to run. Scenario analysis should be easy, but spreadsheets make it hard.
Building financial models with Causal
Causal offers a simpler, more intuitive way to build financial models.
Instead of creating huge spreadsheets full of countless rows and columns, Causal is built around Variables.
You can start off by creating input variables like current revenue and then create variables which define how your inputs change over time (e.g. revenue growth).
Causal fixes one of the major problems with spreadsheets, by being able to account for uncertainty about the future.
Maybe you don't know that your monthly revenue growth will be 4%, but feel confident that it'll be somewhere between 3 and 5%. Causal lets you build variables that account for that uncertainty:
With these simple ideas, Causal lets you build any kind of financial model. You can extrapolate variables forward in time, run scenario analysis with the click of a button, and share your model in an interactive dashboard.
Interested in seeing what a Causal model looks like? Here's a simple, interactive example of a cash flow model.
Tweak the inputs along the top to see how changes in initial conditions, or growth rates, affect the model outputs.