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What is Financial Modeling?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 27 August 2016
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    2003-2016
    Conjecture Corporation
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Financial modeling is a strategy that is often used in business and investing situations. The basic idea behind the creation of financial models is to identify and examine as many possible scenarios and outcomes as possible, as they relate to a particular course of action. Modeling of this type can often help individuals and businesses make more informed decisions on what assets or other investments to secure, as well as what type of products to begin offering to the general public.

With investing, financial modeling is focused on accurately identifying all possible outcomes associated with the future performance of a given investment. The investor drafts a number of different models that take into consideration not only the currently known factors, but also possible future movements in the marketplace, or the impact of political elections on the value of the investment. Some models also include extreme factors such as projecting what would happen to the investment should some type of natural disaster occur. By creating these different models, the investor gets a better idea of the risk involved with securing and holding the investment for a specific period of time.

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Financial modeling can also help a company avoid spending resources on the development, manufacture, and promotion of a product that ultimately fails to attract consumers. By using various models to determine what could happen if certain shifts in consumer preferences take place, or the economy undergoes a downturn, it is possible to consider the amount of risk involved in producing that product. If the models indicate there is a high probability that the product will not generate sufficient revenue to offset the start up costs, the company may choose to focus attention in another direction. At the same time, the financial modeling may lead to ideas on how to refine the specifics of the project in order to maximize the chances of achieving a successful outcome.

In many situations, financial modeling involves the creation of mathematical projections that take into consideration factors like option pricing, the cost of capital associated with each model, the risk inherent with the outcome of each of the models prepared, and the potential for success versus failure. The exact configuration for these projections will vary, depending on the type of action that is under consideration. As long as the formula does include accurate and complete information that is relevant to the achievement of the desired outcome, there is a good chance that the financial modeling will refine production and marketing strategies, as well as set reasonable expectations for the outcome if the project is pursued.

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