Financial Modelling Theory

DEFINING A FINANCIAL MODEL AND FINANCIAL MODELING

A financial model is tool (typically built in excel) that displays possible solutions to a real world financial problem. Financial Modeling is the task of creating a financial model. Financial Modeling is the practice of distilling numerical data with predictive insights and business logic to derive answers to business questions.

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Not every spreadsheet is a financial model. So what differentiates a financial model from an ordinary spreadsheet?

A financial model:

> Is more structured - it contains a set of variable assumptions, inputs, outputs, calculations, and scenarios. It often includes

a set of financial forecasts or reports which are based on those assumptions

> Is Dynamic - changing any of the input or assumptions will lead to a chain reaction that changes other variables

> Shows forecasts - financial models are almost always forward looking (looking into the future). Financial modelers

want to know what their projections will look like down the road

> Contains Scenarios (hypothetical outcomes) - A well built forward looking financial model can be easily used to perform

scenario and sensitivity analysis (what if x happens instead of y, what would be the result)

Types of models

Complex models vs Simple models

Deterministic Models (What-if, Goal Seek) Vs Optimisation Models (Decision-making under constraints)

Simulation models (Monte Carlo simulation – outside scope)

Applications of financial modeling

Data Analysis and Reporting,

Portfolio Management – (Risk, Profitability, Liquidity)3

Financial Planning & Reporting (Management Accounting, Investment Appraisal etc);

Corporate Finance (Valuations etc)

Structure of financial modeling

Financial modeling is a process that involves a six stage life cycle detailed below. The first three stages are planning stages while the last three include building, testing and using the model. Everything that is done under this process should adhere to Financial Modeling Best Practice Standards.

Financial modeling Life Cycle

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SCOPE:- Nature, Scale & Complexity of the model,

SPECIFICATION:- Define logic of the model

DESIGN:- Defining the most effective structure of the model

This course focuses on the last three stages of the life cycle, teaching the formulas and techniques of model development, testing and effective use of many types of models according to best practice. To learn more about best practice standards, please go to the Financial Modeling Standards page.

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