Financial modelling is the process of building a mathematical model designed to represent a real world financial situation, for example the performance of a financial asset or the portfolio of a business, project or any other investment. In short financial modelling is about translating a set of hypotheses about the performance of markets or agents into numerical forecasts.
What is Financial Modelling used for?
Financial modelling is used in two scenarios, one is for accounting and the other is for quantitative finance. In the accounting profession, financial modelling is similar to financial statement forecasting and is used for decision making. These could include decisions on scenario planning, mergers and acquisitions, capital budgeting, cost of capital, business valuations, project finance and more. A financial modeller will build a model around financial statements and use calculations and outputs that are monthly, quarterly or annual.
The quantitative finance model involves the development of a complex mathematical model that deal mainly with asset prices and market movements. These financial models are used for, credit scoring and provision, option pricing and calculation, interest rate derivatives, credit derivatives, real options, portfolio optimisation and others.
Who uses financial models and where?
Financial models and therefore the expertise of financial modellers is used by business owners and entrepreneurs, finance and accountant professionals, consultants as well as individuals for personal finance. They can be used for example to forecast the future need of raw materials, the benefits of a merger or acquisition, to identify undervalued securities, to quantify and predict risk for a business, to check the size of a market opportunity and more.
What are the different types of Financial Models?
There are a variety of financial models that can be used, which we explain in more detail in our article “Types of Financial Models”. Examples include, Comparative Company Analysis models, Corporate finance models, discounted Cash Flow modes, Option pricing models, Leveraged Buy Out (LBO) models, Merger & Acquisition (M&A) models, Sum-of-the-parts models and Industry-specific financial models. These financial models are used to solve different problems and a financial modeller will have the expertise to know which one to use in which situation.
Financial modelling is highly specialised and to be able to build a financial model takes experience and expertise.
