What Is Financial Modeling? Overview and Applications

By Frank Bass – Updated Mar 8, 2025 at 10:14 PM EST

Key Points

Financial modeling predicts a company’s financial performance using historical data.
Financial modeling aids in decision-making for budgeting, investing, and valuation.
Models can apply to diverse areas like M&A, asset management, and corporate finance.

Financial models provide businesses with an overview of their past, present, and expected future performance. It’s used by a wide range of financial professionals, including investment bankers, accountants, researchers, planners, and analysts. Read on to learn more about how financial models are built and used.

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Spreadsheet on a computer — Image source: Getty Images.

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What is financial modeling?

A financial model is a summary of a company’s financial performance that’s used to predict its future. The model can help a company predict a range of outcomes, such as quarterly earnings, monthly revenue, or annual net income.

Although models are useful for predicting performance, they can also be used for a wide variety of business functions. Models are frequently used to determine if it’s profitable to invest in another company, lend money to it, or launch a partnership with it.

Financial models are built with the three main accounting statements:

Income statements display revenues and expenses. They also can include costs of goods sold, gross profit, earnings before income taxes, depreciation, and amortization (EBITDA), and net income.
Balance sheets are used to report a company’s assets, liabilities, and shareholders’ equity, also known as a company’s book value.
Cash flow statements measure the money flowing into and out of a business, generally with sections for cash flows from operations, cash flows from investments, and cash flows from financing.

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Types of financial models

The type of financial model used depends on its purpose. Here are five common types of financial models:

Three-Statement Model: Consists of the three major statements linked in Excel. The model is built so that a change in one statement is reflected in the other two.
Discounted Cash Flow (DCF) Model: Uses cash flow from the Three-Statement Model to value a company, based on the net present value (NPV) of a businesses’ future cash flow.
Merger and Acquisition (M&A) Model: Typically uses a single tab in a spreadsheet for each company and a separate tab for the entity resulting from the merger or acquisition.
Initial Public Offering (IPO) Model: Used to value a business that’s considering becoming publicly traded and make assumptions about investor interest.
Leveraged Buyout (LBO) Model: Builds debt schedules used to finance the acquisition into the model.

Pros and cons of financial models

Well-designed financial models have a number of benefits, including:

Identifying potential risks
Highlighting opportunities for growth
Providing a clear financial picture to potential investors
Helping to allocate resources and determine budgets
Report important information to shareholders

Financial models aren’t without risks, though, including:

Input errors, caused by faulty manual entry or poorly designed code
Incomplete data, caused by variables that aren’t considered or unknown
Incorrect assumptions, either too optimistic or too pessimistic
Unknown unknowns, or failures to account for uncertainties
Missing scenarios, failing to consider possible what-if outcomes

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The bottom line on financial models

Financial models are created by gathering data from core financial statements, identifying factors that could affect future results, creating assumptions and scenarios, and testing the model for accuracy. A well-designed model can provide valuable information, both for internal use and external stakeholders; a poorly designed model can have the opposite effect. It’s important that financial models be designed, maintained, analyzed and vetted thoroughly before being used by decision-makers.

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About the Author

Frank Bass is a contributing Motley Fool stock market analyst and editor covering energy, healthcare, consumer, and financial sectors. Frank has decades of experience in financial journalism, holding reporting and editing roles at The Wall Street Journal, The Associated Press, and Bloomberg. He also currently edits research on the global energy transition. He holds a bachelor’s degree in journalism from Texas Tech University and is a graduate student at the University of Alaska Fairbanks. Fun Facts: Frank has hiked The Long Trail in Vermont from end to end, and currently lives in a semi-dry cabin in Interior Alaska.

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