Financial Modeling Introduction

In finance, there are numerous items which are classified as financial models. Some of them are:

  • Making decisions about whether or not to go ahead with a project.
  • Forecasting profit and loss, cash flows, and balance sheet.
  • Pricing calculations to determine fair price of a new tender.
  • Investment analysis for a joint venture.

and so on.

Some people fail to distinguish financial models and spreadsheets. In a nutshell, Excel spreadsheet is simply a tool that we can use to create financial models. And the way we use Excel or other similar programs like that is called financial modeling.

Models in Excel can be built for various purposes: financial or non-financial, business-related or non-business-related. Some of them are classified as financial models, yet they do not include financial information. For example, in risk management, a model that captures, tracks, and reports on project risks, status, likelihood, impact, and mitigation are just simply conditionally formatted as a colorful, interactive report. In project planning, models may be built to monitor progress on projects, including path schedules or even Gantt chart.

It is often said that Excel is the second-best solution to a particular financial problem. There is usually a better, more efficient piece of software that will also provide a solution but we face some additional problems:

  • Extra licenses, costly implementation
  • Some software could just be installed on some specific computers and/or operating systems
  • Training is needed
  • Some software is produced for either only specific purposes or particular industries, not flexible at all
  • Types of data sources are limited

However, Excel is not really the best option. There is a mounting amount of software on the market which can become alternatives to Excel. There are also a number of Excel add-ins provided by the third parties that can be used to create financial models and perform financial analysis. The best choice depends on the solution required. Financial models are built for the purpose of providing timely, accurate, and meaningful information to assist in the financial decision-making process. Therefore, the overall objective of the model depends on the specific decisions which in turn are to be made based on the model’s outputs.

Once the overall objective has been established, a financial modeling tool that will best meet the requirements can be chosen. To evaluate the degree of the “best-fit”, the following must be considered:

  • who will use the outputs and what the decisions are
  • the volume, complexity, type, and source of inputs
  • the complexity of calculations or processing of inputs to be performed by the model
  • the level of computer literacy of the users
  • the cost versus benefit set off for each tool