A financial model is a mathematical representation of the key variables impacting an organization, which is used to make estimates of how future scenarios will impact the performance and financial position of the business. This model is usually constructed on an electronic spreadsheet, using summary-level revenues and expenses, and employing formulas that change the results of the model when certain variables are altered. For example, variables could be used to model the impact of an increase in energy prices, a decline in product prices, a product recall, a change in the rate of sales growth, or a successful employee strike that results in increased compensation and benefit costs.
A financial model is useful for estimating the effects of a number of scenarios within a short period of time, though its effectiveness depends on how well the model mimics the business. An analyst can use a financial model for a number of purposes, such as:
- Acquisitions. To determine the range of possible outcomes that an acquirer can expect with an acquiree, depending on the actions it takes after the deal has been closed.
- Budgeting. To develop several scenarios as part of the budgeting process, to decide which scenarios to pursue when a detailed budget is constructed.
- Capital budgeting. To determine a range of outcomes that might impact the cash flow return related to a prospective fixed asset purchase.
- Risk analysis. To determine which variables can have the greatest negative effect on a firm, as part of a formal risk analysis.
There are two potential problems with financial models. One is that a model may not properly account for the variables that will impact the model's projected future results. The other problem is that a more complex model is at risk of having calculation errors built into it, which can be difficult to detect.