Objectives of financial modeling and forecasting

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The primary purpose of a Financial Model is to virtually recreate the real business; It shows, emulates and projects the performance of any business. To recreate it virtually, financial experts use the variables to define financial measures. Once these variables are created, it becomes easy for a financial analyst to enter different financial parameters and get the impact of those in the forms of numbers and charts.

These variables, which are called the assumption in financial parlance, are accustomed to predicting the impact of various changes created from company policies or by market ups and downs. These assumptions may include growth rate, operating margins, product prices, commodity price changes, refinancing or recapitalization.

There are several financial models available in the market; Before using or creating a Financial Model, you need to know your business purpose or purpose. For simplicity, the company would have a reason why and what they want to measure regarding business performance. Once the business decides on the objectives of the financial model, it is easy to design the functionality of the financial model to produce the required results.

Types of financial models

Financial modeling enables key personnel to make better decisions. These models are used for various types of decision making. Therefore, one model cannot be used for all types of decision making. As a result, several different types of models must be created. Each of these models requires different inputs and provides different outputs. A good financial modeler should be aware of the basics of these different types of models. There are different types of models created for different types of decisions.

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Some of the important ones have been listed below:

Discounted Cash Flow Model (DCF)
Merger model (M&A)
Model initial public offering (IPO)
Three-statement model
Consolidation model
Budget model
Forecast model
Leveraged buyout (LBO) model
Options pricing model

It should be noted that financial modeling is not a method where an exact process is followed to obtain exact results. Instead, financial modeling is a framework or set of guidelines that provides the means to derive the many financial results reflecting the performance of any business.

In this article, we will discuss the financial forecasting model and why a business needs a financial forecasting model regarding its performance.

What is the Financial Forecasting Model?

Financial forecasting is a vital function in business planning, budgeting and operational management. Business managers, investors, and creditors look at these forecasts to assess expected income and expenses so they can estimate a company’s cash flow throughout the accounting period. A financial forecasting model examines trends in external and internal historical data and projects those trends to provide decision makers with information about how the company’s financial performance is likely to be in the future.

Financial forecasts are an essential tool for key business stakeholders to make decisions about hiring, spending, and financing. It is also used for budgeting by CFOs to properly utilize company resources for profitability. A well-designed financial forecasting model gives you the information about what resources are needed, when they are needed, and how you will pay for those resources.

Most companies use financial forecasts for the coming month, quarter or year. Often, financial forecasts also cover longer periods, such as three or five years. Due to unforeseen factors, if the sales trend is in a different direction, companies use revised forecasts during the base period.

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Objectives of a financial forecasting model

Undoubtedly, when a company forecasts a financial forecasting model, it has a goal that must be achieved by the proposed model. There are mandatory objectives of a well-designed financial forecasting model.

These goals are listed below:

Profitability planning
Liquidity planning
Credit planning
Business valuation
Valuation of financial instruments

Let’s dive deep to explain each of the objectives in detail.

Profitability planning

Profitability planning is a set of assumptions included in a financial plan. It is part of the financial plan and compares a company’s net sales with all expenses for goods, labor and equipment. The profit forecast result is operating profit before tax, depreciation and interest.

For business startups, forecasting profitability is especially important. It is used to demonstrate the viability of your business idea to third parties. Needless to say, no loan will be issued unless the bank verifies that the expected profit covers both the founder’s living costs and the repayment installments.

Thus, a detailed profitability forecast report helps you estimate the success of your investment, convince investors of the economic viability of your business and demonstrate the viability of your business.

An example of a profitability forecast model with five years of profitability forecast is shown below:

Liquidity planning

A liquidity forecast is a prediction of a company’s or market’s cash flow at some point in the future. It allows businesses to identify potential times that available credit sources could not cover cash shortages. Additionally, liquidity forecasting also allows companies to identify if there is excess liquid assets, which can then be used for other initiatives. It helps companies measure their liquidity and manage potential excess or insufficient in advance. On the other hand, liquidity can be committed or uncommitted; In times of volatility, you can significantly reduce uncommitted liquidity, while committed liquidity will remain stable.

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Liquidity forecasts are vital for potential investors. Most investors, before investing, look at the balance sheet to determine the financial strength of the company, and liquidity is the basic indicator.

A company’s liquidity forecast plays an important role and companies realize where the cash will be at some point in the future. Moreover, companies that have strong liquidity forecasts and are well prepared for the future situation are the favorites of investors. Moody’s rating allows investors to assess the relative credit of any company. Thus, greater liquidity provides companies with a better Moody’s rating and makes them more reliable for investors.

An example of liquidity forecasting by a Financial Model is given below:

Credit planning

Business is mainly conducted on credit. Businesses must exercise credit if they wish to increase sales. However, when credit is extended, the risk of default is always present. Therefore, companies must decide whether or not they are willing to extend credit to a third party. If so, the next question is how much credit they are willing to extend. There are credit forecasts that help businesses see the impact of excessive credit on a business’s performance in the future.

Credit forecasts are also useful for investors and lending agencies to assess the company’s ability to meet its obligations. It also indicates the appropriate level of default risk associated with investing in these companies. The credit forecast result helps you predict the impact of credit on your business performance and repayments.

An example of such a credit forecast for five years is given below:

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Business valuation

Financial forecasts also help business owners determine the value of their business and how the business is likely to grow in the coming years. Also, investors and banks are keenly interested in the valuation predictions of the company using their investment.

It guarantees debt repayments on time and allows the business owner to obtain more financing to expand the current business. To predict the value of a business, you can use all the methods available for valuations. The free cash flow method is generally preferred by long-term investors to value a business. It focuses on the operating cash flow generated by the Company and its expected growth rate in the future. A business can use its current free cash flow or its free cash flow if the business intends to make operational changes in the near future.

An example of a valuation forecast with free cash flow is given below:

Valuation of financial instruments

A financial instrument is a negotiable asset of any kind; either money, evidence of an ownership interest in an entity, or a contractual right to receive or deliver money or another financial instrument. The valuation forecasts of certain financial instruments help determine the value of the whole company, or simply its share in the years to come.

Potential investors and financial lenders are keenly interested in predicting the valuation of financial instruments. It helps them secure the value of the business in the event of default. Investment banks and private equity firms use complex financial models to arrive at a valuation for entire companies.

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Below is an example of forecasting the valuation of a financial instrument:

These types of financial models are extremely complex, and it is quite difficult for individuals to design and create such complex models. On the other hand, these financial models have become necessary because financial instruments have become more and more complex nowadays. Since to create such a complex financial model, it has to consider various variables, and it cannot be done using a simple tablet or ordinary programming software.

FinModelslab has made your complex financial forecasting model easy to use. Financial forecasting models designed by FinModelslab automatically execute all complex operations; You don’t need to remember an Excel formula or do the math. Below is one of the financial forecasting models from FinModelslab .

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