What is financial modelling and why do bankers do so much of it?

What is financial modelling?

Financial modelling is a mathematical representation of a financial situation or scenario. It's used to forecast a company's future financial performance based on historical data and other assumptions. Bankers use financial modelling to make informed decisions regarding investments, loans, and other financial transactions. This approach helps to make decisions in an efficient manner and is a fundamental part of trying to reduce risk. Banks use this information to determine which investment they should invest in or not and is also required by various financial regulatory bodies.

Types of financial models

Financial models can take many forms, ranging from simple spreadsheets to complex algorithms, and they can be used to perform a variety of tasks, such as forecasting a company's revenue, calculating the value of a potential acquisition, or evaluating the risk of a loan. Here are three examples of the types of financial models available:

• Finance models: These are used by businesses to determine their profit margins and future growth potentials. They are used by companies to decide whether they should invest in new equipment or hire new employees etc. Finance models help businesses analyze their financial situation and identify areas for improvement.

• Portfolio analysis models: These are used by investors who want to compare one portfolio against another portfolio to decide which has better returns in terms of risk-return profile or other parameters such as volatility etc. 

• Cash flow projections: These projections compare current profit levels with expected sales levels over a given period (typically 12 months). Projections are often made using discounted cash flow analysis. This technique uses an assumed discount rate to calculate the present value (PV) or Net Present Value (NPV) of future cash flows based on interest rates and inflation rates. A PV calculation gives an indication of what future profits might be in terms of today’s money if certain assumptions are met. 

Why it is important to bankers 

1. Decision Making: Financial modelling helps bankers make informed decisions about investments, loans, and other financial transactions. 
2. Risk Management: Financial models can be used to evaluate and manage risk, which is critical in the banking industry. Bankers can use financial models to evaluate the creditworthiness of a borrower, calculate the potential loss in the event of default, and determine the capital requirements for a loan.
3. Communication: Financial modelling provides a standardised and transparent method for evaluating financial situations, making it easier for bankers to communicate financial information to stakeholders such as clients, regulators, and investors. This can increase confidence in the accuracy of the financial information being presented.
4. Compliance: Financial modelling is also important for compliance purposes. Regulators require banks to maintain certain levels of capital, and financial models can be used to calculate the required capital levels. This helps banks ensure they are in compliance with regulations and helps to prevent financial instability. 

Financial modelling is not a new concept. It has been around for centuries, but in recent years it has become more complex and sophisticated. In fact, bankers have become so enamoured with the idea that they spend up to 80% of their time doing financial modelling that they are often under-employed in other aspects of their job.