The decisions you make as an entrepreneur will make or break your company. Every business owner, including HVAC contractors, carries the heavy burden of ensuring the sound financial future of a business. Financial modeling is one of the essential tools for business owners and managers when making financial decisions.
While no crystal ball gives futuristic insight, financial modeling can simulate scenarios that help entrepreneurs make proper decisions. That is done by building a financial representation of a real-world business situation. You can then use extrapolated data to assess the economic impacts of possible changes or predict future financial performance.
In rapidly growing industries like HVAC, you want decisions that ensure your company’s longevity and competitiveness against other contractors. A financial model can help you do just that.
Here, we’ll go in-depth at what is financial modeling, how it works, and financial modeling projects you can use.
What is Financial Modeling?
Financial modeling is a tool businesses use to project the likely future performance of a business. Financial models base the outcomes using the company’s historical performance and assumptions about future variables like revenue and expenses. You can use the information obtained from the model to guide your strategic planning and decision-making endeavors.
At the core of every financial model are the financial forecasts made by the business prior. Financial modeling uses the assumptions found in the forecast. They play assumptions out using financial statements to predict how the statements look in the future.
A blanket financial modeling tool doesn’t exist. Businesses need different models to make sound decisions depending on their goals, and there are specific financial modeling tools for budgeting, valuation, raising capital, etc. Familiarization with other models is key to guiding businesses through empirical information.
Purpose of Financial Modeling
The purpose of financial modeling varies depending on who you’re talking to. For example, an HVAC contractor may use it to price out a service and estimate their financial risk. In contrast, a financial analyst will use it to value a company or predict its future stock.
In its broadest definition, financial modeling creates a simplified representation of a financial situation. It can range from a spreadsheet showing your company’s monthly sales to models used to price out a new product.
Financial modeling is crucial for HVAC businesses because it allows managers to make informed business decisions. That includes pricing, financial risk, and future growth.
Think of it this way.
While financial forecasts give insight into events likely to happen, financial modeling examines hypothetical scenarios. It allows business owners to model “what if” scenarios to assess how situations and decisions impact a company’s performance. This analysis becomes the grounds for futuristic financial choices.
Who Uses Financial Modeling?
Anyone interested in determining a company’s financial outlook can use financial models. However, some people conduct financial modeling as a typical job description. Each of them uses different models for various reasons, usually depending on the focus of their business.
Here are the people that build and use financial modeling, plus some reasons why they use it:
- Company Management – to develop long-term financial plans and strategize financial decisions based on hypothetical futuristic variables
- Entrepreneurs – to assess the future financial viability of their business idea
- Equity Research Analysts – to produce in-depth reports on the stock market industry
- Credit Analysts – to assess the futuristic creditworthiness of a business or an individual
- Risk Analysts – to measure and manage financial risks of performing business actions
- Data Analysts – to interpret helpful information and prepare reports that their clients can use for decision-making
- Portfolio Managers – to help them strategically design investment portfolios for clients
- Investors – to better understand a company’s financial status before investing
Applications of Financial Modeling
Financial models take more than quantitative financial exercises for business owners. On top of financial forecasting, an in-depth analysis of financial statements is also insightful.
Financial modeling can be used as long as you can access spreadsheet applications like Excel and Google Sheets. However, the process itself takes effort and other prerequisites before one can access the list of insights it offers.
Below are some applications of financial modeling:
- Business valuation and stock valuation – determining the economic value of a business or the intrinsic value of a stock.
- Scenario planning and management decision-making – this deals with “what is,” the “what ifs,” and “what steps to be taken.”
- Capital budgeting – evaluating if capital can support potential major projects or investments.
- Financial statement analysis – reviewing and analyzing a business’s financial statements.
- Ratio analysis – one of the financial analysis tools used to understand a company’s liquidity, operational efficiency, and profitability.
- Revenue management – allows companies to handle their sales tactics better, run operations, offer better pricing and keep inventory low.
- Project finance modeling – determine the economic feasibility of a project.
- Cash flow forecasting – investigating or forecasting a company’s future financial position
- Credit decisioning – the steps that businesses or credit professionals take before credit approval or decline
- Working capital and treasury management – the management of holdings to ensure normal daily operations and mitigate financial risks
- Management Accounting – measurement, analysis and interpretation of financial information
Some Examples of Financial Modeling
Depending on the situation’s demands or your goals, you’ll require different financial models. Every financial modeling tool differs in type, complexity and use. Below is a breakdown of some of the most used financial modeling examples.
Three Statement Financial Model
The three-statement financial model is the most standard and comprehensive form of financial modeling. This model illustrates the complete economic setting and projections of a company.
As the name implies, this model uses and interlinks all three financial statements:
- Cash Flow Statement
- Balance Sheet
- Income Statement
There are also schedules you can integrate to support the data. It includes the depreciation schedule, working capital calculation schedule and debt schedule, among others.
Users thoroughly understand all components in the model and their respective effects. What sets this model apart is the interlinking between the financial statements. It allows users to tweak inputs based on forecasted oscillations that will reflect the entire model.
The three-statement financial model is helpful for understanding trends given a set of inputs. It can display historical data as far back as conception and up to 2-3 years forward.
The M&A model is a helpful tool for understanding a company’s merger or acquisition effects. It specifically looks into the earnings per share (EPS) of the newly formed company post-restructuring. The data is then used to compare with the current EPS.
- If the EPS increases, the transaction is described as “accretive.”
- If the EPS goes lower than the current EPS, it’s said to be “dilutive.”
The type and size of a company’s operations influence the comprehensiveness of the resulting M&A model in question. Investment bankers and corporate financing institutions use this model, but business owners need to know how this works.
Forecasting models are tools businesses use to project future outcomes on business aspects like sales, supply, demand, consumer behavior, etc. Different forecasting models correspond to distinct degrees of information. It may range from simple forecasting models to more complex ones.
There are various ways to accomplish forecast models, but four primary methods are used to predict future actions. Here are they:
- Time series model — This forecasting model uses past data patterns to predict future behavior. It helps visualize data better when you clearly understand how variables historically interact.
- Econometric model — This is a more complex model often used in economics to predict future economic developments. The process uses complex economic theory and statistical methods.
- Judgmental forecasting model — Unlike other forecasting models, this type is subjective and relies heavily on the judgment or experience of the forecaster. It is often used when there is little or no historical data to work with. Focus groups and expert panels can provide insights that computerized models never could.
- The Delphi method — This is a structured technique used to gain opinions from a group of experts. It involves sending out questionnaires and analyzing the responses. This process is repeated until there is a consensus among the experts.
Discounted Cashflow Model (DCF) Model
The DCF model is one of the most utilized methods of valuation. It revolved around the idea of the Time Value of Money. This concept states that money received in the present is of higher value than in the future.
DCF model states a company’s value is the Net Present Value (NPV) of the sum of future cash flows. They base this presumption on how much money a company will generate in the future. In other words, this financial modeling attempts to analyze the value of an investment today.
This modeling tool helps determine an investment opportunity. If the NPV of the sum of future cash flow is higher than the current value, it’s a profitable venture. Otherwise, it’s not worth it.
Comparable Company Analysis (CCA) Model
CCA operates under the presumption that one can understand the valuation of a company by looking at its peers. In other words, you get a ballpark figure of a valuation. Metrics of similarly-sized businesses within the same industry will share almost similar valuation multiples. A common multiple is EV/EBITDA, the ratio between enterprise value and earnings before interest, taxes, depreciation and amortization.
Since this only looks at the valuation ratio, it is one of the most essential financial modeling tools used. A high valuation ratio means a company’s share is overvalued, while a low ratio indicates undervalued.
Asset and Liability Management (ALM)
Financial institutions use asset and liability management (ALM) to mitigate financial risks caused by mismatches between assets and liabilities. ALM strategies combine risk management and financial planning. Companies usually utilize these to manage any long-term risk that may arise from changing circumstances.
Capital Budgeting Model
The financial model for capital budgeting is used to assess the profitability of long-term investments. Capital budgeting can cover any investment like real estate and even fixed asset purchases. That can mean anything from new HVAC units to fleets, even an entirely new office building for an HVAC contractor.
The rate of return is always measured for any proposed investment. For example, a charitable project is often disapproved because of the lack of rate of return. Exceptions are when a business wants to foster goodwill and contribute to the community via a social event.
Leveraged Buyout Model (LBO)
LBO is deemed one of the most aggressive financial modeling strategies. In a leveraged buyout, a company acquires other companies via borrowed money to meet the cost. The cash flow of the newly acquired company is then used to pay off the debt associated with the sale.
Acquiring businesses then sell-off the bought-out business after years of gaining substantial profits. LBO models aim to determine how much profit can be made from a leveraged buyout sale.
Option Pricing Model (OPM)
Option Pricing Models or OPM are mathematical models, unlike other subjective methods. For this reason, they are described as more or less straightforward than other models. The OPM is used to calculate the theoretical value of an “option” or a type of contract between two parties.
The theoretical value of an option estimates what the choice would be worth considering all inputs. In other words, OPM provides users with a fair value of the option. This financial modeling strategy is particularly pertinent for options trading.
Required Set of Necessary Skills in Preparing a Model
The skills required to create a financial model are extensive. With training and practice, anyone can develop the ability to build a financial model. With that, acquiring the benefits of a better understanding of how your actions can affect your HVAC business. Below is a list of skills:
- Intermediate Understanding of Generally Accepted Accounting Principles
- Intermediate Excel Sheet Skills (formulas, etc.)
- Intermediate Forecasting Skills
Financial modeling may seem daunting at first. However, any smart business owner can master advanced modeling tools.