So, most of the time when I have interviewed candidates, I ask them the importance of financial modelling 99.9% of the time, the answer is that it helps us forecast future financials. While, I am not saying that, the answer is wrong but you missed out the broader benefit. Which is decision making.
Going from Data to Wisdom: The Importance of Financial Modelling
Now, let me put up some scenarios which would be rather simple. What I want you to notice, is the bridge that financial modeling creates for that crucial “Yes” or “No”.
Structuring Your Plan
For a moment imaging you are planning your investments for retirement. And you are thinking, where do I start thinking about this? That’s the beginning of the importance of financial modeling.
So, may be your financial modeling brain starts thinking about the process and comes up with the following structure;
- Firstly, what is my source of income and what are my expenses?
- Secondly, what will be probably my aspirational income needed to meet aspirational expenses in the future.
Now, suppose the lifestyle you want to maintain 20 years from now looks like 1.5 Lacs per month today. So, then what amount would you need to save and in what you need to save is where the importance of financial modeling kicks in.
Just imagine this for a sec! You are an entrepreneur who has no family history of business and you want to start a business. So, as a layman you think. I will start a restaurant. Your friends cheer you up and you are willing to invest Rs. 50 Lacs to start the business. But only to realize the following
- That the Restaurant or food business in general is the worst business to start with.
- The margins are low and initial investment is high.
So, would you still bet your 50 Lacs. Hence the importance of learning financial modeling, helps you in answering these questions before you commit.
Tweaking the Plan
The importance of financial modelling is also realized when I must change gears. Sometimes, I can make the best plans on a spreadsheet, but the word is a complex place to operate. Hence, as soon as I start implementing a plan it might not go as planned, which requires that you make changes. But the question is what?
For example, you might realize that your sales have started dropping, hence you might have to tweak the price but how much will you reduce. How will affect your margins? How will it effect your cash flows?
Assessing your risk
No matter how safe an investment might look like, it does carry risk. But at the same time not all risk is bad, because without risk there is no return. So, how much risk are you willing to take? Also, there might be options which give you the highest return for the lowest amount of risk in the category. Again a crucial aspect, for the importance of financial modelling.
Everything can be valued including your house, car, land, gold. And eventually everything is valued basis the cash it can generate in the future. So the importance of financial modelling in valuation is unparalleled.
For this let’s assume you are going to start a transport business. Where you take passengers from one point to another. Now imaging the moving factors that can effect your profitability? Firstly fuel, second the number of passengers, thirdly maintenance, or interest rates. So now financial modeling can actually run these scenarios without any manual work which helps in decision making
So, businesses can optimize of taxes by pre-planning expenses which are beneficial for it. Which also requires financial modeling. For example; let’s say you have a business and you want to increase the expenses but at the same time use those expenses for the benefit. So, you see that your machinery is outdated and is consuming higher fuel. Now, if you are able to upgrade the system, then your output can improve while improve cost but at the same time also give you extra depreciation expense, which reduces tax liability
Best Practices for Success with Financial Modelling
Now, let me discuss some of the best practices to incorporate while using this tool. So that you gain the maximum benefits.
Your model is as good as the data and assumptions. The lower the accuracy of your data the lower the quality of output
High Quality Research:
Always and one of the most important advice while using financial modeling is to do the best research. The better the research, the more conviction you will have on your financial model
A financial model is like a map, which needs to be upto date with new information. For example; you are making a financial model for a publicly listed company. If there is new business information in the quarter related to drop in demand or rise in raw material expenses. Then you must update this to make your map usefull.
FAQ’s on Importance of Financial Modelling
Why Financial Modeling is so crucial for business’s
The bigger companies for sure use this tool but for smaller business’s this becomes even more critical. Because if you have to take the best possible decisions which can match up to the standards then your best option is with the best plan which is using financial modeling
Who primarily use Financial Modeling?
So, financial modeling is used in investment banking, equity research, credit analysis, Risk management and even trading models
What the structure of a financial model?
The basic structure of a financial model, is data( In a valuation model, that could be financial statements), second is the metrices of the model( Again in a business that means business drivers), and final is the decision parameters( For eg In business it is NPV, IRR, Intrinsic value etc)
How to Learn Financial Modeling?
There are many ways of learning financial modeling. You can do self study using our youtube playlist of financial modeling, or you can also join our full time live online courses to learn this and also get placed in finance