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What is Financial Modeling and What Purpose does it serve in the BFSI Sector?

What is FinancialModeling and How Does it Help Financial Professionals?

If you ask any banker or financial expert what financial modeling is, they’ll quickly rattle off cost-benefit analysis, cash flow predictions, Net Present Value, the projected rate of return, and break-even points.

Furthermore, those of you who aspire to be bankers or financial professionals, particularly Investment Bankers, are likely to have been exposed to financial modeling from your undergraduate days. Financial modeling is something that everyone in the BFSI (Banking, Financial Services, and Insurance) industry should be familiar with because it is the lifeblood of their industry. So, what is financial modeling and why is it so critical?

To begin, imagine that you, as a consumer, have asked for a loan to acquire a home, a vehicle, or other costs such as weddings, or even personal loans to support your spending habits.

When you go to a bank or a financial institution, the banker or financial expert must now assess your creditworthiness and the dangers of lending to you. This can only be done if he or she can estimate your capacity to repay the loan during the period for which it is being sanctioned, and to do so, they must “model” how your repayment profile will appear in the future based on your prior credit history, current income, and projected earnings.

This is where financial modeling comes in helpful, as it provides a data-driven and quantitative way to “mapping” where you stand in terms of financial soundness and health in comparison to others.

As a result, financial modeling presents a comprehensive image of your financial situation and creditworthiness to lenders and financial specialists.

From the Micro to the Macro: Financial Modeling Up and Across the Value Chain

Extrapolate the same to huge borrowers like industrial conglomerates, massive organizations, or even states requesting help and loans from multilateral lending institutions like the World Bank, IMF, ADB, and AIIB (Asian Infrastructure and Investment Bank).

The required financial models, which are built using sophisticated and advanced financial modeling approaches, will play a key role in determining whether loans for these firms may be awarded.

Furthermore, investment bankers use financial models to advise potential clients on whether their planned Mergers and Acquisitions, Takeovers, and Outright Purchases of other businesses will be financially advantageous in the short, medium, and long term.

Bankers and financial specialists cannot appraise or assess if a project, a loan, an investment, or a substantial tranche of the bailout to nations is justified from a strictly financial standpoint without simulating the various eventualities.

The Analogy of the Doctor and the Nuts and Bolts of Financial Modeling

Indeed, just as doctors and medical professionals use financial modeling to arrive at a diagnosis and, more importantly, a prognosis based on the patient’s past medical history, the results of various tests, and the patient’s current condition, financial professionals use financial modeling to arrive at their recommendations.

Future cash flows, projected balance sheets for the next five years, estimated profit and loss (if any) for the coming years, and the IRR or Internal Rate of Return based on how much yield the project would provide to the undertakers, and most importantly, the NPV or Net Present Value of the project so that exit clauses can be drawn up that can be triggered are typically used in financial modeling.

Though financial modeling may be done with Excel spreadsheets in its most basic form, as we progress up the financial value chain, more sophisticated and specialized software is employed to model.

Technology and the Persistence of the Human Element

Furthermore, the rate of change in the models utilized has been so rapid in recent years that Hedge Funds and Investment Bankers are increasingly using AI or Artificial Intelligence-powered and Big Data-driven financial modeling to arrive at their models.

Even the best and most advanced models developed by the so-called Masters of the Universe failed to “read the tea leaves” and judge which way the wind was blowing during the Global Financial Crisis of 2008, as evidenced by the failure of even the best and most advanced models developed by the so-called Masters of the Universe to “read the tea leaves” and judge which way the wind was blowing.

Having said that, if we ignore the failures, we may conclude that financial models, on the whole, hold up to inspection, however, the competence and knowledge of the human element is a factor in the models’ success or failure.

While we talk about AI and other cutting-edge technologies augmenting and even replacing humans in decision-making positions where large investment decisions must be made, it is still the case that the financial professional’s ability to model the past, present and future financial health of various projects, loans, and investment decisions makes a difference in the models’ eventual success or failure.

Compass and Guidepost

Finally, without financial modeling, all of our financial decisions would be akin to the story of the Blind Men and the Elephant, in which each of them comes to a conclusion that is both individually and collectively incorrect. As a result, financial models can be said to provide us with a compass with which we can navigate the turbulent financial waters and unpredictable storms that lay ahead of us.

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