What are financial models?

- [Instructor] Financial modeling. To some folks, myself included, it's truly a joy to work in this space. To others, it probably just sounds like boring old business jargon. Well, it isn't quite that bad, is it? Believe it or not, financial modeling is actually something that we come up against in everyday life, even if we're not necessarily aware of it. Now, hear me out. Imagine that you are cooking dinner and natural light is fading, so you go to turn on the light switch. Boom, the globe has blown. Now, at this moment, you are probably more concerned about overcooking the veggies than replacing the globe, but at some stage, you are going to have to head to the hardware store for a replacement. Once you're there, you'll be overwhelmed by the magnitude of choices available. Do you just go for a good old fashioned incandescent globe? After all, they're pretty cheap to purchase. Or do you get a compact fluorescent globe? They're more expensive, but use much less power and last longer. And in recent years, we've seen the proliferation of LED globes. These are even more expensive to purchase, but use even less power than the alternatives and last even longer than the other two choices. Now, if you've ever tried to do the maths to help solve this problem, well then guess what? You've kind of already done financial modeling. Financial modeling is the process of taking numbers and data and turning them into some kind of predictive tool to assist with decision making. In our relatively simple example of replacing a light globe, modeling the ongoing costs of the various options available helps us decide on which one to purchase. How so, you might be wondering. Well, it may actually be the case that the cheapest globe to purchase, in this case, an incandescent globe, ends up costing more in the long run. Now pause for a moment and just imagine how valuable this kind of analysis can be when it comes to multimillion dollar enterprises that are presented with scenarios such as this every day. What you're looking at here is a visual from a financial model that I developed for a fictitious business. In this example, I wanted to replicate a real world scenario where a company wants to compare the cost of building a new finance system in-house versus leasing it. As you can see, purchasing a new finance system in-house has an initial investment spike and then smoothed annual running costs. And then finally, a small peak at the end to decommission the asset. Contrast this with the same solution that's provided via software as a service. The monthly running costs are much higher, but there's no investment spike because my client didn't need to purchase anything such as software or infrastructure. Believe it or not, over the expected useful life of the system, that is seven years, leasing actually worked out to be the cheaper of the two options. This here is a relatively simple scenario, but it should give you a taste for exactly what a financial model is.