A financial model is a representation of an entity’s financial statements and accounts in a spreadsheet format that can be modified to gain useful insights.  Typically, a financial model will focus on future results.  The model will project, by using specified inputs, a future financial picture in an income statement, balance sheet, and cash flow statement format.  In addition to these financial statements, models often contain useful physical measures (units sold, tons of raw material, etc.).  All of this information is used to provide useful analysis to decision makers.

A financial model does not predict the future, but it allows people to understand parameters about the future that are insightful and not readily understood without using a spreadsheet model.

Uses of a Model

Many financial models are used to value a business activity or answer a valuation question.  For example, A hotel developer might want to understand many things about a potential project:

  1. Given standard assumptions, what is the internal rate of return (IRR) on the money invested in the project?
  2. How many rooms need to be filled to meet debt (bank) obligations and avoid bankruptcy?
  3. If adding an amenity (such as spa) allows me to charge more for a room, how much more do I need to charge to break even?
  4. If my partners require 20% return, how much can I pay for the land?
  5. Will I be able to use the projected cash flow from my other hotels to fund construction?  What if costs over-run by 15%?  What if there is a 6 month delay?

A financial model, when properly constructed can answer these questions.  Notice the type of question being asked.  The model will help you understand the “if A is the case, then B happens” type questions.  It won’t typically tell you whether a project is “good” or “bad”.  The business person’s analysis of all of the model results forms this decision. 

If the model says the hotel must be 75% full to just pay the debt, what does that mean?  Obviously, if the hotel must be 110% full, or the Holiday Inn must charge more per night than the Four Seasons (and the other assumptions are good) there is a problem.  The model tells you the location of the pin, the size of the fairway, and the condition of the course, you must decide whether to tee off, what club to use, and how to hit.

Models also are helpful in planning situations.  A common planning exercise with a model is examining quantities based on financial growth or vice versa.  A company that thinks it will grow at 15% per year in revenue might want to know how many sales people it needs to hire each quarter given training and effectiveness lag time.  A sophisticated model could examine financial and physical scenarios that compare overtime and outsourcing against plant expansion or new capacity.