When asked to define financial model, many people come up with long-winded descriptions using terms like forecast and cash flow and hypothetical outcomes. But the definition needs to be that complicated. A financial model is a tool (typically built in Excel) that displays possible solutions to a real-world financial problem. And financial modeling is the task of creating a financial model.
You may have thought that a financial model was basically just an Excel spreadsheet, but as you know, not every spreadsheet is a financial model. People can and do use Excel for all kinds of purposes. So, what makes a financial model distinct from a garden-variety spreadsheet? In contrast to a basic spreadsheet, a financial model
- Is more structured. A financial model contains a set of variable assumptions — inputs, outputs, calculations, and scenarios. It often includes a set of standard financial forecasts — such as a profit-and-loss statement, a balance sheet, and a cash flow statement — which are based on those assumptions.
- Is dynamic. A financial model contains inputs that, when changed, impact the calculations and, therefore, the results. A financial model always has built-in flexibility to display different outcomes or final calculations based on changing a few key inputs.
- Uses relationships between several variables. When the user changes any of the input assumptions, a chain reaction often occurs. For example, changing the growth rate will change the sales volume; when the sales volume changes, the revenue, sales commissions, and other variable expenses will change.
- Shows forecasts. Financial models are almost always looking into the future. Financial modelers often want to know what their financial projections will look like down the road. For example, if you continue growing at the same rate, what will your cash flow be in five years?
- Contains scenarios (hypothetical outcomes). Because a model is looking forward instead of backward, a well-built financial model can be easily used to perform scenario and sensitivity analysis. What would happen if interest rates went up? How much can we discount before we start making a loss?