Why is Financial modelling Important for Business?
Ceteris paribus must be the most used term in the field of economics; at the same time, the same term creates the biggest disconnect between real-world and academia. In the real world, all the variable are constantly changing and are interlinked. Furthermore, businesses have grown far bigger and more complex. In today’s world, businesses source capital from different markets, sell their products globally and exploit cost-saving opportunities worldwide. As the globalized world is creating more opportunities, it is also adding many variables in business decision making. In such a scenario, financial modelling has become a necessary tool for managers and entrepreneurs.
Financial models help in assessing the financial impact of business decisions. Before embarking on any change in the business or starting a new initiative, economic impact analysis in a simulated environment can save businesses from financial blunders. Concurrently, the business managers can deploy capital in the projects, which are likely to create more value for their shareholders.
Financial models can be used for multiple purposes like financial budgeting, investment evaluation, business valuation, business stress testing. Depending on the nature of the business, some of these uses of the financial model may attract more attention. Infrastructure companies are heavy users of financial models for assessing financial feasibility of their projects. Due to very thin margins in the infrastructure development business, a small error in cost estimation can seriously jeopardize the profitability of the project. As infrastructure projects have very little flexibility in changing execution path or cost structure, wrong cost estimation or cash flow timing discrepancy may leave the developer with a loss-making project, which it cannot abandon midway. Thus, checking the financial feasibility of the projects and running all possible scenarios through a robust financial model is the most critical part of the decision making for Infrastructure development companies.
On the other hand, the new age technology start-ups use the financial model to assess funding requirement, predict hiring requirements, set development targets and rationalize the use of the monetary resources, which are very scars at the stage. New ventures can take many development paths and each path has its own challenges and benefits; a detailed simulation in the financial model can provide valuable insights to entrepreneurs for choosing the right development path for them.
Apart from financial analysis, financial modelling can be very helpful in standardizing financial decision-making processes across the business; standard pricing sheets and cost sheets are very good examples for the same.