What is a financial model?

Woman at a computer viewing financial reports

A financial model is a tool used to forecast the financial performance of a business or investment. It is an essential tool for decision-making and strategic planning and helps communicate goals and direction to key leaders and stakeholders.

Start with data

The model is built on a solid foundation of accurate and relevant data, coming from a variety of sources, including historical financial statements, market research, and industry benchmarks. It is important to ensure that the data used is reliable, consistent, and reflects the unique characteristics of the business.

The model should include projections for revenue, expenses, cash flow, and profitability over a defined period, typically three to five years.

In addition, it may also include sensitivity analysis to assess the impact of various assumptions and scenarios on the financial performance of the business or investment. This allows decision-makers to evaluate the potential risks and rewards of different courses of action.

A tool for communication

When building a financial model, it is important to be transparent about the assumptions used and to document the methodology and calculations behind the projections. This not only ensures accuracy but also facilitates communication and understanding among stakeholders.

A financial model should be flexible and adaptable to changes in the business or investment environment. This means that it should be updated regularly to reflect new data and insights, as well as changes in the market or regulatory landscape. Comparing budget to actual each month provides an opportunity to learn, correct course, or celebrate.

Chief Financial Officer

While most CPA firms can put together a model or budget, the professional typically responsible for providing financial strategy and leadership to a business is the Chief Financial Officer (CFO). A CFO builds and regularly updates the model, providing key analysis and observations when compared with actual monthly results.