Financial modeling is a valuable tool for forecasting process. It is used in the forecasting process, asset risk assessment, capital planning, budget analysis, cost accounting, control, EBITDA or earnings before interest, taxes, depreciation and amortization, equity valuation, and business cycle analysis. This process of predicting future financial performance of a particular company is commonly referred to as fiscal forecasting.
Financial modeling can be divided into two groups; operational and analytical financial modeling. The former requires more financial modeling expertise, while the latter is comparatively easier. Before starting financial modeling process, it is essential to understand the operational/accounting process as well as its relevance in the financial analysis process.
While doing financial modeling, the team needs to assess the level of complexity of the data used in the calculations, the reliability of data collection methods, the ability of the system to predict the future based on the current historical data, and the consistency of the mathematical model being used. These aspects are important for developing an accurate and reliable financial model.
As we all know, the financial analytical model being used for forecasting purposes depends on the past experience of the company. The same applies to a financial modeling process.
The advantage of using analytical, financial modeling is that the model is developed based on the past experience of the company. The past experience includes both actual and simulated financial operations of the company. The benefits of using these models for forecasting purposes include identifying the companies' strengths and weaknesses, which have a direct impact on the operation of the company.
The next step of the modeling process is to create a priori model of the companies' strengths and weaknesses based on the previous economic model. This prior model allows the management team to detect the strengths and weaknesses in their present-day operations. For this purpose, an analysis of past performance is required.
The results of the past economic analysis is used to estimate the firm's current profitability, cash flows, and potential future earnings. In addition, the process also determines the stability of the financial structure and provide an estimation of the financial risk. The same methodology is applied for allocating capital as well as for estimating the debt levels of the company.
Financial modeling is basically a strategic decision making process. It involves analyzing current data and past performance of the company to determine the factors that lead to the profitability of the company. This process is followed during the forecasting process.
Once the modeling process is complete, the forecasts are used to aid in the forecasting process. The forecasts are taken as information about the company's future performance, and hence, serve as evidence to support the management team's decisions.
There are several sources for using the models. These include sample, numerical, and statistical methodologies.
When using the model, it is essential to first examine the model and understand its assumptions. The process involves different elements including financial modeling models, analytical, financial models, cost-effectiveness analysis models, quantitative risk analysis models, and economic models. All of these models are essential to the process of development of future financial models.