Introduction
Financial modelling involves building a model or abstract representation of a real world financial situation. The financial model so developed can be used to forecast a business’ future financial performance for decision making.
What financial modelling involves
As alluded to above financial modelling entails coming up with tools or models to forecast a business’ future financial performance. The forecast is usually based on the following information:
- A business’ historical performance, normally extracted from annual, management accounts or other financial reports for prior periods.
- Assumptions about the future as is normally done for annual budgets or strategic planning. Assumptions can be global, country specific, industry or business specific.
- Projected Income Statements for example for one year or longer.
- Projected cashflow statements.
- Projected Statement of Financial Position (Balance Sheet).
Types of financial models
There are many types of financial models used by entities of different types and sizes. Example include the following:
- Costing and pricing models
- Budgets
- Business valuation models
- Capital investment appraisals
- Valuation of financial assets or instruments
- Cost of capital
- Ratio analysis
Use of ratios is quite established and popular. Some of the ratios used include:
- Profitability analysis
- Revenue analysis
- Expense analysis
- Segmental reports and analysis
- Working capital including liquidity models
- Solvency ratios
Costing and pricing models
Businesses normally develop models for pricing their products, for example cost-plus model. A price may be arrived at using a model that includes cost elements such as raw materials, labour, production overheads absorption rates, non – production or administrative overheads and a profit mark up.
Budgets
Corporates usually have templates for annual budgets. These budgets include various assumptions on for example market share, prices, exchange rates, volumes, gross profit margin or mark up, expenses, net profit margin or mark up. A change in the variable inputs will change some of the results such as profitability.
The same assumptions may apply to even projected cashflows or business valuations.
Valuation of business or shares
Various models are used to value a business or its shares. Common examples include the Discounted Cashflow Method (DCM), also called the Net Present Value (NPV) method. Other models include Net Assets, Price – Earnings Ratio.
By using “what if” or “sensitivity analysis” models different values or a range of values can be estimated if variable inputs are varied during the workings.
Capital investment appraisals
Before capital projects such as new investment or expansion are undertaken such projects are assessed through capital investment appraisal models. These may include the DCM or NPV method, Payback period, Internal Rate of Return (IRR), Accounting Rate of Return (ARR), Return of Investment (ROI) or Return on Capital Employed (ROCE).
Valuation of financial assets
It is quite common in financial services such as banks to come up with models to value financial assets or instruments such as bonds, treasury bills, etc. Factors fed into a model may include projected inflation, opportunity cost, exchange rate, etc. The Capital Asset Pricing Method (CAPM) is widely used in some economies.
Cost of capital
A model can be developed to estimate actual or desired cost of capital of a business. Such a model can be in the form of Weighted Average Cost of Capital (WACC) which may provide for equity and debt component in financing a business. WACC is normally used for capital investment appraisals or business valuation.
Profitability ratios
Over time businesses develop models to show or manage profitability through for example segmental profitability, product profitability, gross profit margin or mark up, net profit margin or mark up.
Revenue analysis
Models may also be developed to show revenue contributions per segment, geographical location, product type. Refer to annual company reports for examples. Future projections will help a company decide on which areas to focus on including resource allocation, risk management, opportunity maximisation.
Expense analysis
This is a very critical area. Over time an industry or company develops known cost or expense standards. These can be in the form of a proportion or percentage of revenue, cost per unit or such costs categorized into classes. For example mining cost being so much per ounce, in insurance claims being measured against premiums. Standard losses or wastages rates may be set e.g. shrinkage. The finance function of a business should keep a close eye on costs as these have a bearing on profitability, liquidity or even viability of a business.
Segmental reports and analysis
In addition to disclosing the actual performance numbers pie charts can also be used to show segmental reports. In a group company segments may include mining, construction, health, banking or geographical segments may include Zimbabwe, SADC region or international operations.
Working capital models
It is established practice for an industry or business to develop a working capital management model. For example current assets to current liabilities cover of say 2:1. Even quick ratio being the number of times current assets less inventories cover current liabilities is widely used. It is quite common in financial services businesses such banking and insurance to have prescribed or recommended liquidity ratios.
Solvency ratios
Models can be developed to measure solvency for example debt to equity ratio, capital adequacy, etc.
Documenting financial models
Financial models in businesses are documented in different ways. These may be in the form of practice or policies, Excel spreadsheets or computer programs or software where algorithm is used.
Conclusion
Financial modelling is key in business. Running a business with inadequate or outdated models is like driving a car which has no dashboard or has one that is not functioning.
Disclaimer
This simplified article is for general information purposes only and does not constitute the writer’s professional advice.
Godknows Hofisi, LLB(UNISA), B.Acc(UZ), CA(Z), MBA(EBS,UK) is a legal practitioner / conveyancer, chartered accountant, corporate rescue practitioner, and consultant in deal structuring and is an experienced director of companies. He writes in his personal capacity. He can be contacted on +263 772 246 900 or gohofisi@gmail.com
