Financial models help determining the financial implications of business decisions – if the model is appropriate for the respective demands!
Applications of financial models
Possible applications for financial models are manifold, whether decisions about new products, markets, or the selection of appropriate financial instruments must be made, whether it isabout pricing for acquisitions or sales of companies, calculating returns/yield for strategic alternatives, or analysing the effects of potential opportunities or risks.
In all these scenarios and many more, financial models help quantifying results and making them comparable. Furthermore, financial models are also needed for annual financial statements, to substantiate the values of investments and goodwill.
There is one important condition: The respective model must be suited for its purpose!
Requirements financial models must meet
So when is a model really suitable as a foundation for a decision? What makes a good model? We believe that there are five key points:
- Full mapping of drivers and targets: All relevant economic factors must be identified in advance and then integrated into the model – be it new customer acquisition, price pressure, cyclicality, market growth, or dependencies, for example on US Dollar rates or oil price. The same applies to the output indicators the model should provide.
- Accuracy and clarity in structure and format: This is a must – a model must calculate properly! And a good model can also be quickly understood by third parties, so it should feature visual differentiation between input and output, as well as formulas that are legible, as short as possible and free of errors.
- Consideration of interrelations: Real-life interdependencies must be reflected in the model. If for example sales increase, this will affect some expense and balance sheet items. The same applies to interactions of market-related input factors.
- Finding the right balance: Too few data make a model inaccurate; too many data make it confusing and prone to errors. This should already be taken into account during model planning, which is part of good model design.
- Flexibility: Companies change over time, and so do the demands on established models. This should be taken into account when designing the model, so that subsequent changes and extensions can be correctly implemented. Scenario analysis may also be foreseen from the outset.