Introduction to Financial Modelling
Principles of Excel as a Modelling Tool
Excel Operations, Structures and Short-Cuts
Introduction to Excel Functions
Applications of Lookup and Reference Functions
Planning and Building Models for Optimal Decision Making

1.3 Financial Modelling: Objectives, Applications and Process

A “financial model” is simply one for which the real-life situation is in economics, business or finance. Financial models may also use large data sets or databases as part of their inputs, and so there is a close link with general data analysis (a link which is discussed in detail in later materials).

General Purpose of Financial Models

In general, the purpose of financial modelling is to assist in the identification, design and selection of the best course of action to achieve some objective.

More specifically, modelling can help to:

  • Assess the feasibility of a particular course of action, business or project.
  • Ensure that the decision processes are as robust and transparent as possible.
  • Make explicit the decision criteria that will be used (and calculate or forecast these).
  • Focus the decision process on the key factors and relevant items that affect a situation.
  • Improve one’s understanding (or beliefs or hypothesis) of the situation, including the degree of control or influence that one has over which items, and the residual areas of risk and uncertainty.
  • Establish the nature and availability of data about the situation.
  • Establish the impact of particular scenarios or uncertainties and risks to a forecasted value.
  • Set targets knowing the requirements and likelihood of reaching them.
  • Highlight the need for additional actions or changes to original plans, targets or beliefs.
In summary, by assessing the effect of actions that are under one’s control, one can create and test alternatives, choose the best, and appropriately manage the risks and uncertainties.

Modelling process are often described in the context of helping to make a “decision”. We will also use that terminology from time-to-time. However, this needs to be interpreted in a broad sense (i.e. to design and select he best course of action) rather than the narrow sense of simply “yes/no” (decision) for only a single possible course of action.

Typical Areas of Application of Financial Models

Financial models are used in many areas:

  • For general forecasting, planning, budgeting, and resource planning.
  • To assess performance and set targets.
  • To evaluate investment projects and of portfolios of projects.
  • To analyse data sets and statistics not only to populate inputs of the model, but also to implement data-driven predictive calculations.
  • To understand risks and uncertainties and optimise decisions and exposures.
  • To value enterprises, corporations, debt and equity, of bespoke financial instruments and derivatives, of legal contract clauses and real options.
  • To forecast aggregate business performance and corporate planning. One may wish to determine finance needs,  establish the debt capacity of projects or corporations, understand credit risk, or assess merger synergies, and so on.

Financial Modelling in Excel

Excel is the most widespread tool used to build financial models (by direct numerical implementation, coupled with background knowledge and appropriate documentation). The CertFM Program therefore covers a wide set of modelling-related functionality and functions in Excel, as well as its ever-increasing tools to manipulate and analyse data sets.

However, to master financial modelling (in Excel), one needs knowledge that goes far beyond the direct use of Excel. Notably, a good knowledge of economic theory, finance, decision analysis, and statistical methods (amongst others) are all required: These are all topics which are separate to Excel in concept, even as using Excel can help to create a better understanding of them, and to implement many aspects in practice.

Thus, Excel is the focus of the methods used within the CertFM Program, even as many other topics and concepts are also covered.

The Financial Modelling Process

The modelling process consists of several possible steps:

  • A specification stage. This may contain some qualitative steps (such as the drawing of influence diagrams or mapping the possible decision structures and options), as well as some mathematical aspects (such as expressing some relationships in mathematical terms).
  • An implementation stage. This is the expression of the model in numerical terms (e.g. in Excel or in some other programming platform).
  • The in-use stage, where the model is used to support decisions in some way.

In the “mathematical” approach to modelling mentioned in the last section, the “modelling” is considered to consist only of the first stage: If this is done correctly and in sufficient depth, then “only” the implementation and the associated decision-making remains.

In the “direct numerical implementation” approach to modelling (as also described in the last section), it is the specification stage which is typically de-emphasised (or largely overlooked as an explicit step): The relationships captured only by the formulas built into the Excel file, and not by a separate explicit (or external) reference. In such cases, it is implicitly assumed that the behaviour of the real-life situation is either standardised, or provided by knowledge that is common or is available to users through some other route. In fact, this discussion highlights one of the weaknesses of main Excel modelling processes, and notably the potential to create better models by having more rigorous approaches to the specification and documentation stages (than is often the case).

The materials within the CertFM Program aim to ensure an appropriate balance between concepts and implementation, including aiming to ensure that the approaches used are transparent and based on sound logic.

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