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

What is Financial Modeling and How Does it Help Financial Professionals?

Ask any banker or for that matter any financial professional what financial modeling is and they would reel off cost benefit analysis, cash flow projections, Net Present Value, expected rate of return, and break even points in a single breath.

Further, for those of you who are aspiring to be bankers or financial professionals and especially Investment Bankers, no doubt that you would be acquainted with financial modeling right from your college days.

Indeed, financial modeling is something that no one in the BFSI (Banking, Financial Services, and Insurance) sector cannot know since it is the very lifeblood of their work. So, what exactly is financial modeling and why it is so important?

To start with, suppose you as a consumer has applied for a loan for you’re to be purchased house, vehicle, other expenses such as weddings, or even personal loans to fund their consumption habits.

Now, when you approach a bank or a financial institution, the banker or the financial professional must gauge how creditworthy you are and what the risks are in lending to you. this can be done only if he or she can project your ability to repay the loan over the time period for which the loan would be sanctioned and for this, they must “model” how your repayment profile would look like into the future based on your past credit history, present income, and future earnings.

This is where financial modeling comes in handy as it offers a data driven and quantitative approach to “mapping” where you stand with regards to the soundness and financial health when compared to others.

Thus, financial modeling provides bankers and financial professionals with a clear picture of your financial standing and creditworthiness.

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

Now, extrapolate the same to large borrowers such as industrial conglomerates, big corporations, or even for that matter, nations seeking aid and loans from multilateral lending institutions such as the World Bank, IMF or the International Monetary Fund, ADB or Asian Development Bank, and AIIB or Asian Infrastructure and Investment Bank.

The decision as to whether loans for these entities can be granted would be determined to a large extent by the relevant financial models that are developed based on sophisticated and advanced financial modeling techniques.

In addition, investment bankers using financial model to advise prospective clients about whether their proposed Mergers and Acquisitions, Takeovers, and Outright Purchase of other business entities would be worthwhile from a financial perspective over the short, medium, and longer term.

Thus, without modeling the various scenarios, bankers and financial professionals cannot judge or assess whether a project, a loan, or an investment, or a large tranche of bailout to nations is justified from a purely financial point of view.

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

Indeed, in the same manner in which Doctors and Medical Professionals arrive at the diagnosis and more importantly prognosis, based on the patient’s past medical history, the results of the various tests, and the present condition of the patient, financial professionals arrive at their recommendations using financial modeling.

Typically financial modeling is done by using the various financial statements as described earlier wherein 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 the Internal Rate of Return based on how much yield the project would provide to the undertakers, and most importantly, the NPV or the Net Present Value of the project so that exit clauses can be drawn up that can be triggered as per viability.

Though, in the basic form, financial modeling is done using Excel Spreadsheets, as we move up the financial value chain, sophisticated and advanced software is used to model.

Technology and the Persistence of the Human Element

In addition, in recent years, there has been such a dizzying pace of change in the models used that Hedge Funds and the Investment Bankers now use AI or Artificial Intelligence powered and Big Data driven financial modeling to arrive at the models.

Indeed, while all this sounds exciting and glitzy, one must remember that financial models do fail at times as was seen during the Global Financial Crisis of 2008 where even the best and the 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.

Having said that, if we leave out the failures, it can be said that by and large financial models do stand up to scrutiny though the skill and the expertise of the human element is something that determines the success or failure of the models.

Indeed, while we do talk about AI and other cutting edge technologies augmenting and even replacing humans in such decision making positions where large investment decisions have to be taken, it is the case that even now it is the ability of the financial professional who models the past, present, and future of the financial health of various projects, loans, and investment decisions to make a difference to the eventual success or failure of the models.

Compass and Guidepost

Lastly, without financial modeling, all our financial decisions would be akin to the tale of the Blind Men and the Elephant where each of them arrives at a conclusion that is individually as well as collectively wrong and hence, it can be said that financial models provide us with a compass with which we can navigate the turbulent financial waters and the unpredictable storms that lay in our path.