In today’s fast-paced business world, making the right decisions often comes down to having the right data. And whether you’re starting your own venture, putting money into the stock market, or running an established company, knowing how financial models work can make a big difference.
These models help you see the bigger picture, whether it’s forecasting revenue, assessing risk, or figuring out what your business is really worth.
In this article, we will explain what is financial modeling, the types of financial models, how they are built, where they are used, and how you can begin learning this valuable skill, even as a beginner.
What is a Financial Model?
What is a financial model? Simply put, a financial model is a tool, usually built in Excel or similar spreadsheet software that represents the financial performance of a business or project. It includes calculations, assumptions, charts, and forecasts that help understand how a business might perform in the future based on current or expected conditions.
In simple terms, a financial model is a way to show a company’s financial situation using numbers and calculations. It helps you see how different decisions or changes like a drop in sales or rise in costs, might affect the business. So, if you’re wondering what is financial modeling, it’s the process of creating these models using company data, key financial ratios, and “what-if” scenarios to support important business decisions.
Why Are Financial Models Important?
Financial models are not just for large corporations. They are essential for:
- Startups planning fundraising and growth
- Investors analyzing business value
- Finance teams forecasting revenue and expenses
- Decision-makers evaluating risks and returns
Key benefits include:
Forecasting future performance: Predicts how much a business might earn or spend in the future, helping plan for profits and challenges ahead.
Capital planning: Shows how much money a business needs, when it’s needed, and how it can be raised or managed efficiently.
Investment analysis: Helps assess whether an investment opportunity is financially sound and likely to deliver returns based on future projections.
Risk management: Uses scenarios to test different outcomes, helping identify and prepare for financial risks or opportunities in advance.
Strategic planning: Supports big decisions like mergers or expansions by showing potential financial impacts and aligning them with long-term goals.
If you work in stock market advisory services or financial planning, financial models help you clearly see opportunities and handle risks.
Key Components of a Financial Model
A financial model isn’t just numbers on a spreadsheet. It has a clear structure and key components. These include:
1. Assumptions
The heart of every model lies in its assumptions. This includes projected growth rates, cost of goods sold (COGS), interest rates, tax rates, etc.
2. Revenue Projections
This estimates how much money a company expects to earn. It can be based on units sold, pricing models, or subscription rates.
3. Expense Forecasts
Covers both fixed and variable expenses, including salaries, rent, utilities, and marketing.
4. Income Statement
Also known as the Profit & Loss statement, it reflects profitability by calculating revenue minus expenses.
5. Balance Sheet
Shows the company’s assets, liabilities, and equity over time. It helps assess the business’s financial health.
6. Cash Flow Statement
Projects how cash moves in and out of the business. Vital for assessing liquidity and operational efficiency.
7. Financial Ratios
Financial Ratios are used for analysis and benchmarking, such as profit margins, debt-to-equity, return on equity (ROE), and current ratio.
Types of Financial Models
There are several types of financial models, each suited for different situations. Here’s a breakdown of the most common ones:
1. Three-Statement Model
This model connects the income statement, balance sheet, and cash flow statement to show a complete financial picture. It’s the base for more complex models and essential for decision-making.
2. Discounted Cash Flow (DCF) Model
It estimates a company’s value by predicting future cash earnings and adjusting them to today’s value. Often used by investors and analysts during valuation, especially for equity analysis and stock research.
3. Leveraged Buyout (LBO) Model
Used in private equity to check if buying a company using debt is profitable. It includes loan repayments, interest, and expected returns after selling the business later.
4. Merger & Acquisition (M&A) Model
Helps evaluate financial effects of merging with or acquiring another company. It considers cost savings, deal costs, and changes in earnings per share—important for strategic growth planning.
5. Budgeting Model
Used by companies to plan and manage finances. It sets targets for spending, tracks revenue, and compares real performance against the budget to ensure proper control and resource allocation.
6. Forecasting Model
Projects a company’s financial future, usually over several years. Unlike budgets, it’s more flexible and often includes best-case, worst-case, and realistic projections to guide long-term decisions.
7. Scenario and Sensitivity Models
Tests different financial outcomes by adjusting key inputs like sales or costs. Useful for seeing how changes in one factor can affect the overall business performance and risk exposure.
Common Use Cases of Financial Models
Financial models have widespread applications across industries and business functions. Here are some real-world uses:
1. Business Valuation
Investors and acquirers use financial models like DCF (Discounted Cash Flow) to estimate a company’s value, helping them decide whether to buy, invest, or hold based on future earnings and expected returns.
2. Fundraising
Startups use financial models to show their revenue potential, costs, and growth projections. These models help convince venture capitalists or angel investors to fund their business ideas and expansion plans.
3. Budgeting and Forecasting
Finance teams use models to set financial goals, allocate resources, and predict future income and expenses. This helps businesses stay on track and make informed adjustments as needed.
4. Expansion Planning
When businesses consider growing through new locations, products, or markets, financial models help measure expected profits, costs, and risks, supporting better strategic decisions before committing funds.
5. Investor Presentations
Financial models are often part of pitch decks to show how money will be spent, how the business will grow, and what return investors can expect, building trust and credibility.
Financial Modeling in Excel: Basics to Know
Most models are built in Microsoft Excel, making it a critical tool for anyone learning what is financial modeling. Here’s what you need to know:
1. Key Formulas
2. Formatting Best Practices
- Use consistent formatting: color code inputs (blue), formulas (black), and links (green).
- Keep a clean, logical layout.
3. Error Checks
- Always include checks to verify your model’s accuracy—like balance sheet balancing (Assets = Liabilities + Equity).
4. Naming Conventions
- Use clear names for sheets, rows, and ranges to keep things organized.
5. Avoid Hardcoding
- Place all assumptions in a separate section and link them to your calculations.
Excel is also used to create dashboards for visual presentations. For advanced users, tools like Python or financial modeling software can add automation and complexity.
Examples of Financial Models Used in the Real World
Let’s look at some financial modeling examples used in real businesses.
1. Startup Financial Models
Startups often build a five-year financial projection model to raise funds from investors. This model includes assumptions about revenue growth, user acquisition, operating expenses (burn rate), and funding requirements.
Let’s understand this with an example:
Assumptions (Year 1)
- Users (starting): 10,000
- Monthly user growth rate: 10%
- Revenue per user per month: ₹100
- Monthly expenses (fixed): ₹5,00,000
- Monthly variable expenses (₹30/user)
- Planned fundraising milestone: After 12 months
Step-by-Step Calculation (Month 1 to Month 12)
Step 1: Calculate Users Each Month
Users grow by 10% monthly. So:
- Month 1: 10,000
- Month 2: 10,000 × 1.10 = 11,000
- Month 3: 11,000 × 1.10 = 12,100
- Month 12: Approx. 31,384 users
Total users in Year 1 (sum of all months) – 2,44,000
Step 2: Calculate Revenue
Revenue = Users × Revenue per User per Month
- Average monthly users ≈ 20,000
- Monthly Revenue = 20,000 × ₹100 = ₹20,00,000
- Yearly Revenue = ₹20,00,000 × 12 = ₹2.4 Crores
Step 3: Calculate Expenses
- Fixed Expenses = ₹5,00,000 × 12 = ₹60,00,000
- Variable Expenses = ₹30/user × 2,44,000 = ₹73,20,000
- Total Expenses = ₹60,00,000 + ₹73,20,000 = ₹1.33 Crores
Step 4: Calculate Burn Rate & Runway
Burn Rate = Expenses – Revenue (if negative cash flow)
In this case:
- Monthly Burn = ₹20,00,000 – ₹11,10,000 = ₹8,90,000 profit
- But in early months, revenue may not cover costs.
Assume first 6 months have a burn rate of ₹3,00,000/month
- Burn over 6 months = ₹18,00,000
Step 5: Fundraising Milestone
To raise funds, the startup includes projections like:
- User growth: From 10,000 to 31,000+ in one year
- Annual revenue target: ₹2.4 Cr
- Target funding: ₹1.5 Cr to support expansion and cover burn
Investors use this model to assess:
- Is the growth realistic?
- Are the expenses optimized?
- Will funding result in profitability or scale?
2. Project Finance Model
Used to evaluate large infrastructure or real estate projects. It includes debt service coverage ratios, construction costs, and timelines.
3. Franchise Expansion Model
Helps determine the financial impact of opening new franchise locations by analyzing capital costs, break-even points, and ROI.
4. Business Plan Model
Entrepreneurs use this to support loan applications or internal planning. It covers expected cash flows, costs, and sales projections.
Such financial modeling examples help you see the practical application of theory in industries ranging from tech and healthcare to real estate and retail.
Tips to Build a Robust Financial Model
Building a model isn’t just about crunching numbers. It’s about making sure it’s reliable, understandable, and decision-ready.
1. Start with Clear Assumptions
All calculations depend on assumptions—make them realistic and well-documented.
2. Ensure Consistency
Follow a consistent format across worksheets, formulas, and data entry.
3. Make it Flexible
Allow easy updates to variables like growth rates, cost inflation, or capital expenses.
4. Use Scenarios
Incorporate “best-case,” “worst-case,” and “most likely” scenarios to test robustness.
5. Link Everything
Avoid hardcoded values. Instead, use references to ensure easy updates.
6. Keep it Simple
Don’t overcomplicate with too many variables unless necessary. Simple models are easier to interpret and audit.
By applying these practices, your models will become powerful tools aligned with your financial ikigai, that sweet spot where financial knowledge meets purpose.
Conclusion
Financial models are critical tools that help businesses, investors, and individuals make informed decisions. Learning how to build and read them is a valuable skill.
You don’t need to be a finance expert to get started. With practice, online courses, and a good understanding of Excel, anyone can begin their journey into what is financial modelling.
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FAQs on Financial Models
What is the purpose of a financial model?
A financial model helps predict future business outcomes. It supports decisions like investment evaluation, fundraising, budgeting, and risk analysis.
What are the most common types of financial models?
The most common include the 3-statement model, discounted cash flow (DCF), budgeting model, forecasting model, and scenario-based models.
Is financial modeling only for finance professionals?
No. While finance professionals use it regularly, entrepreneurs, business founders, product heads, and analysts also benefit greatly from learning what is financial modeling.
How accurate are financial models?
Financial models are only as accurate as the assumptions behind them. Including multiple scenarios improves reliability and helps manage risk.
What tools are used for financial modeling?
The most widely used tool is Microsoft Excel. Others include Google Sheets, Python (for automation or analytics), and specialized financial modeling software.
Can I learn financial modeling online?
Absolutely. Many free and paid courses teach financial modeling basics, with templates and real-world financial modeling examples. It’s a skill worth building for long-term professional growth.
