Financial modelling is the process of creating a summary of a company's expenses and earnings in the form of a spreadsheet that can be used to calculate the impact of a future event or decision. It is a representation in numbers of some or all aspects of a company's operations.

A financial model has many uses for company executives. It is used to anticipate how a company's performance might be affected by future events or to inform executive decisioning.

Decision Making

Financial models are intended to be used as decision-making tools. Company executives might use them to estimate the costs and likely profits of a proposed new initiative.  They also are used in strategic planning to test various scenarios, decide on budgets, and allocate corporate resources. In times of stress, they are used to suggest where the biggest savings may be had for the least operational change.

In an ideal scenario, the information needed to model finances and to perform sensitivity analyses are all available in the corporate knowledge management tool. But if not, Aston Beck consultants are skilled at surfacing what is needed.

Financial analysts use them to anticipate the impact of an economic policy change or any other event on a company's share price.  They are also used in the valuation of a business or to compare businesses to their peers in the sector they operate in.

Types of Financial Models

Examples of financial models relevant now may include the three statement model, discounted cash flow analysis, the budget model and associated forecasting model, or the in-depth appraisal.

A model is only as good as the data that is input and the assumptions that are made.

The Three Statement Model
The three statement model is the most basic setup for financial modelling. The income statement, balance sheet, and cash flow are all dynamically linked. The objective is to set it up so all the accounts are connected and a set of assumptions can drive changes in the entire model.

The Discounted Cash Flow (DCF) Model
The DCF model builds on the three statement model to derive a company's value based on the Net Present Value (NPV) of the business’ future cash flow. The DCF model takes the cash flows from the three statement model, makes some adjustments where necessary, and then discounts them back to today at the company’s Weighted Average Cost of Capital (WACC).

Budget Model
Our friends in financial planning & analysis (FP&A) model the budget for the coming year.  Budget models are typically designed to be based on monthly or quarterly figures and focus heavily on the income statement.

Forecasting Model
FP&A build a forecast that compares to the budget model, and is helpful to predict cashflow. Sometimes the budget and forecast models are one combined workbook.

In-depth Appraisal
An appraisal is an unbiased analysis or evaluation of an asset, a business or organisation, or to evaluate a performance against a given set of standards or criteria.

  • Business assets are commonly appraised, especially in instances when the business may cease operations. In doing so, the appraiser is looking to determine the assets’ book value, by deducting the business’ liabilities from its assets.
  • A more popular method for appraising a business is by determining its historic earnings. In capitalisation of earnings, the documented earnings in the past are looked into and given weight. The appraiser gives the most weight to the most recent earnings, and progressively less and less weight to older earnings records.
  • In contrast, an appraisal of discounted future earnings looks at the anticipated future earnings of a business. After the projected earnings are determined, a discount rate is used, the greatest weight to present earnings and less to future earnings.

Current concerns

Many companies will be seeing lower revenue, resulting in less cash flow, along with delayed receivables collection - at a time when important suppliers will still want paying.

Companies should expect to become much more nimble in managing inventory given the uncertainty in the supply chain, which will also place demands on working capital.

What to do now

Progress each of the four actions set out below, as soon as possible.

Understand minimum cash and liquidity requirements
Assess availabilty of cash and of liquidity headroom. Get a clear view on how much cash you have globally and where it is located. Assess if is readily available for use, or it access is restricted. Determine the key cash flows that may be exposed. Awareness of cash reserves or shortages, along with the liquidity position, will be a starting point for identifying opportunities to protect and improve your position.

Establish a robust short-term cash flow forecast
Model your cash needs for the next 1, 3 & 6 months, including staff costs. Make sure that your forecast identifies contraction trigger events and quantifies the impacts. Triggering events may include borrowing-base deterioration or a covenant breach. Identify if your existing organisational structure, processes and tooling can handle impact quantification demand.

If not, this is the time to move as fast as you can to turn your company digital.

Run multiple scenarios
Model different scenarios and what-if analyses, such as a drop in sales or a reduction in cash collected, and be prepared to revise them often. Model preoduct-by-product, market-by-market, region-by-region and roll up to an overall view.

If you wait for the complete picture, you’ll be too late to make any difference.

Scenario planning gives the Exec the confidence needed to make decisions and to shape communications about the response strategy.

Take actions to protect your position
Once you understand your financial position, then you must take action to protect liquidity and assess working capital requirements. This will necessitate identifying the financial and operational levers that can be pulled to conserve and generate cash and potentially increase access to funding.

Typically these levers might include

Improving credit and collection capability.  For example, assess customer credit risk, offer discount for early payment

Control the flow of outgoing payments. For example minimise discretionary spending, defer capital expenditure, review vendor relationships and delay payments, implement cost reductions that that an immediate cash benefit.

Size inventory to sales.  For example, challenge forecasts and replenishment triggers, tightly control production targets.  Don't automatically accept new orders - check that their fulfilment doesn't add stress to the situation.

Deploy financial tactics. For example, repatriate cash that is stuck in store safes, or trapped overseas. Consider renegotiating covenants, opening new credit facilities or investigate supply chain financing.