The perfect financial model helps you see into the future of your business. It applies past trends to forecast future performance, test new assumptions, and support strategic initiatives with quantitative backing. But building one isn’t always straightforward. Here’s what you need to know to build an effective, flexible financial model.
Whether you’re scaling fast or just getting started, your business has many moving parts—burn rate, valuation, cash flow, and more. Each one affects the others. Add macroeconomic shifts, and things get complicated quickly. Financial modeling helps you forecast these changes and ground your planning and decision-making in data.
It’s the foundation of every strong FP&A (financial planning and analysis) strategy.
What is a financial model?
A financial model is a structured, numerical representation of your business. It helps quantify performance, simulate outcomes, and guide planning.
Most finance teams build models in Excel or Google Sheets using interlinked formulas. If the model is set up correctly, you can adjust a variable—like revenue projections—and immediately see how it affects cash flow, EBITDA, or runway.
Core use cases include:
- Company valuation
- Revenue forecasting
- Budgeting
- Scenario planning
- Merger/acquisition analysis
The purpose of modeling is to understand how changes—whether planned or unexpected—might impact your business performance.
Not all models are the same. Some are foundational tools you’ll use regularly. Others are built for a specific moment, like fundraising or M&A. Here’s a breakdown of the most common types.
7 types of financial models
Each financial model answers different questions and suits different contexts. These seven are widely used:
Discounted cash flow (DCF)
Used primarily for valuation, the DCF model estimates future cash flow and discounts it back to present value using the time value of money. It’s common for investment analysis, though less suited to high-growth SaaS companies with negative free cash flow.
Three-statement model
This combines the income statement, balance sheet, and cash flow statement into one connected model. It’s a baseline model that supports scenario testing and more advanced modeling like DCF or LBO.
Leveraged buyout (LBO)
The LBO model projects returns on an acquisition made with a high proportion of debt. It’s complex, involving multiple financing structures and circular references.
Merger model
This forecasts the financial impact of a merger or acquisition, typically tracking earnings per share to assess whether the deal is accretive or dilutive.
IPO model
This model estimates a company’s potential valuation in a public offering. It uses market comps and past valuations to set pricing expectations.
Option pricing model
Used to value options or derivatives, common methods include Black-Scholes, binomial trees, and Monte Carlo simulations.
Sum-of-the-parts model
Used when a company has multiple distinct business units or assets. Each part is modeled separately, and the values are combined for a more accurate overall valuation.
How to create a financial model in 4 steps
There’s no single way to build a model—but here’s a reliable process:
1. Define your objective
Are you modeling to support a fundraise? Plan for headcount? Forecast new revenue streams? Clarify the question you’re trying to answer before you build.
2. Gather data and set assumptions
Start with historicals and key inputs. These vary depending on the model type but typically include headcount, revenue, expenses, and balance sheet metrics. Pressure-test assumptions against industry benchmarks and internal trends.
3. Build your model
Populate your financial statements and structure the model clearly. Color-code inputs and formulas, label assumptions, and make the model usable across teams—not just for finance. For SaaS businesses, track monthly recurring revenue (MRR) by product or segment.
4. Test and refine
Check the math. Run sensitivity analyses. Adjust assumptions to explore different outcomes. Keep the model updated as your business evolves.
The importance of data and technology
A financial model is only as reliable as the data it’s built on. Manual errors or outdated inputs can derail decisions. Modern tools help reduce risk by automating data pulls from systems like your HRIS, CRM, or ERP—creating a single source of truth.
Dashboards that visualize key metrics also help teams stay aligned and spot issues early.
Advanced modeling techniques: Scenario planning
Scenario planning helps you prepare for uncertainty. You can model a downturn in revenue, a shift in hiring plans, or a major capital expense—and understand the implications before they hit.
Some financial tools support this by generating baseline projections, which you can then adjust to test a range of scenarios.
AI also plays a growing role in financial modeling—helping uncover hidden trends, automate budgeting, and validate projections.
Best practices—and common modeling mistakes
Do:
- Build models tailored to your business
- Document assumptions clearly
- Keep models clean and user-friendly
Avoid:
- Hardcoding values that should be dynamic
- Using out-of-the-box templates without customizing them
- Relying on outdated or inconsistent data
Financial modeling FAQs
What’s the difference between financial forecasting and financial modeling?
Forecasting helps with short-term operational planning—like managing liquidity month to month. Modeling creates simulations for longer-term decisions.
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What are common financial modeling pitfalls?
Errors in formulas, over-reliance on templates, and unlinked data points can all lead to misleading outputs. A solid model is accurate, dynamic, and reflects the nuances of your business.
Can software help build better financial models?
Yes. Tools that automate data entry, support real-time collaboration, and offer built-in scenario planning can improve accuracy and efficiency. Just remember: tech is only as valuable as the thinking behind it.
A solid financial model doesn’t just answer questions—it helps you ask better ones.
