Budgeting Basics and Beyond

18.1. A Financial Model

A financial model, narrowly called a budgeting model, is a system of mathematical equations, logic, and data that describes the relationships among financial and operating variables. A financial model can be viewed as a subset of broadly defined corporate planning models or a stand-alone functional system that attempts to answer a certain financial planning problem.

A financial model is one in which:

• One or more financial variables appears (expenses, revenues, investment, cash flow, taxes, and earnings).

• The model user can manipulate (set and alter) the value of one or more financial variables.

• The purpose of the model is to influence strategic decisions by revealing to the decision maker the implications of alternative values of these financial variables.

Exhibit 18.1 shows a flowchart of a simplified financial planning model.

Financial models fall into two types: simulation, better known as "what-if" models, and optimization models. "What-if" models attempt to simulate the effects of alternative management policies and assumptions about the firm's external environment. They are basically a tool for management's laboratory.

Optimization models are ones in which the goal is to maximize or minimize an objective such as present value of profit or cost. Experiments are being made on multiobjective techniques, such as goal programming.

Models can be deterministic or probabilistic. Deterministic models do not include any random or probabilistic variables, whereas ...