Financial Modeling Techniques and Applications

Businesses navigate an increasingly complex and continually evolving risk landscape. Geopolitical conflicts, cyberattacks, inflation, natural disasters, pandemics, and other threats can significantly affect the global economy and individual organizations.¹ In this turbulent environment, financial modeling helps companies identify growth opportunities and mitigate risk.²

Financial modeling uses math, statistics, and other disciplines to analyze financial data and predict future outcomes. Businesses often use financial modeling techniques to explore possible consequences of their actions and make informed decisions.² This article examines popular financial modeling approaches and practical applications for this useful tool.

Understanding Financial Modeling

The Federal Reserve System defines financial modeling as “a quantitative method, system, or approach that applies statistical, economic, financial, or mathematical theories, techniques, and assumptions to process input data into quantitative estimates.”³ In other words, a financial model uses academic theories to analyze accounting and business metrics and make data-driven predictions.

Financial models have many practical applications in all industries. Businesses can use modeling techniques to perform tasks such as:³

• Assess the adequacy of resources
• Detect potential risks
• Disclose financial information to the public and stakeholders
• Evaluate business strategies
• Generate reports for regulatory agencies
• Make significant financial decisions, such as merging with another company or securing a new investment
• Manage assets
• Perform stress tests
• Project future sales trends

Models serve many useful functions, but they may also pose certain risks to companies. Because these tools try to forecast events and trends that haven’t occurred yet, they’re inherently uncertain. As a result, they may lead businesses to make risky decisions based on incorrect or flawed predictions.³

However, finance professionals can reduce model risk by conducting model validation. This process examines every part of a financial model to detect errors and ensure that the model works as expected. Model validation also helps identify limitations in the model so that business leaders can account for these imperfections when making decisions.³

Financial Modeling Techniques

Financial analysts, investment bankers, and other business professionals use a broad range of techniques to create financial models. There are several factors to consider when selecting an approach, including available data, objectives, and the time span of the analysis. The techniques often used include these:

Forecasting

Forecasting estimates a company’s future financial performance based on past and present data and industry trends. Finance professionals often use forecasting to make short-term financial models. For example, a company could create financial forecasts at the beginning of each quarter or fiscal year to develop more accurate budgets and predict future revenue.⁴

Other common types of forecasting include:⁴

• Cash flow forecasting: Businesses can forecast how much money they’ll gain and spend over a given period
• Demand forecasting: Companies use historical data and market trends to anticipate demand for their products or services so they can maintain adequate inventories
• Expense forecasting: This method allows companies to anticipate future costs that can reduce profits
• Startup cost forecasting: New ventures use this model to determine how much capital they’ll need to operate in their first year

Forecasting also enables businesses to predict how decisions like expanding to a new market or raising prices may affect their short-term performance.⁴

Scenario Analysis

Scenario analysis evaluates how future events could impact a business’s operations and performance over a long-term period. This method allows finance professionals to predict the effects of a wide range of deterrents, such as cyber threats, government collapse, hiring shortages, new technological developments, and terrorism.⁵

Business leaders can use scenario analysis to plan how they would respond to possible situations to achieve the best possible outcome for their company. This technique also allows companies to identify their strengths and weaknesses so they’re better prepared to act in case of crisis.⁵

Valuation Models

A valuation model assesses the current or future worth of a company, an asset, or an investment. An analyst can use six factors to create a valuation model for a business:⁶

• Analysis of cash distributions to shareholders
• Historical changes in the company’s debt-to-equity-ratio
• Past and present economic conditions in the industry
• Market volatility in regions where the company and its competitors are located
• Weighted forecasts of the company’s revenue growth
• Weighted forecasts of the company’s margin growth

This data allows finance professionals to forecast how a company’s value will change over time. Leaders can also apply this knowledge to identify differences between their company and competitors and take steps to increase their company’s value. In addition, a valuation model makes it easier for companies to make informed decisions about mergers and acquisitions.⁶

Monte Carlo Simulation

The Monte Carlo simulation–also known as the multiple probability simulation–uses statistical analysis to predict every possible outcome of an uncertain scenario that involves one or more undefined variables. The simulation assigns many different random values to these variables and runs the scenario repeatedly, generating numerous outcomes. Finally, the simulation takes the average of these outcomes to estimate the most likely result.⁷

The Monte Carlo method has many practical applications. For example, investors can use this technique to predict the likelihood of earning a profit from an investment. Finance professionals can also use the Monte Carlo simulation to estimate the future value of portfolios.⁷

Make the Smartest Investment in Your Future

Business leaders increasingly rely on data analytics and financial modeling to anticipate future challenges and make strategic decisions. In the Leavey School of Business at Santa Clara University, the Online Master of Science in Finance and Analytics (MSFA) program can help you develop the skills to guide organizations through uncertain economic times.

Our Online MSFA program will prepare you for a competitive career in corporate finance, capital markets, and other fast-paced business environments. Led by expert faculty, you’ll learn how to develop sophisticated financial models and strengthen your analytical skills. Our robust curriculum features career-focused courses including Econometrics, Corporate Finance and Financial Analysis, Fintech, and Financial Engineering.

Additionally, the Online MSFA program offers multiple enrollment options to fit your individual goals and schedule. You can complete the program in as little as a year, all the while gaining the dedicated attention, expanded network, and career support you need to succeed.

To move your career ahead, make an appointment today to talk with one of our admissions outreach advisors.