Financial models serve an important role in project finance. They allow investors to identify and assess the potential risks associated with a particular project and determine the degree of risk they are willing to take on.

Likewise, they allow companies to gauge the financial impact of potential investments and assess if the project is viable. You can use financial models to project financial risks, such as the risk of default on payments, the effect of changing market conditions on cash flow, and the likelihood of successful completion.

In this guide, we discuss the areas you should focus on when constructing a model for projecting financial risk in a project. We also look at how to use Financial models to assess the probability of success and determine the best course of action.

What Are Finance Risks?

When running a startup, it is crucial to consider the various risks associated with finance. These include, but are not limited to:

• Cost Overruns: The cost of a project can be highly volatile, and overruns can quickly occur if not managed properly.
• Default Risk: Defaulting on payments is always a risk, especially for longer-term projects.
• Political Risk: Political risk is the potential that government policy or regulatory changes could affect the economics of a project.
• Market Risk: Changes in factors such as commodity prices, interest rates, and exchange rates could adversely affect the profitability of a project.
• Operational Risk: Poorly defined processes and operations could lead to inefficient use of resources and reduced profits.
• Maintenance Risk: If the project is not adequately maintained, it could lead to higher costs and reduced profit.
• Syndication Risk: The involvement of banks or other financial institutions in a project can significantly increase the risk of default.
• Supply Risk: What if factors like supplier availability or cost of materials change?

It’s essential to project finance risks because you shouldn’t only be prepared for the base scenario. Rather, every company should be prepared for the best and worst-case scenarios.

How to Use Financial Models to Assess Risks

Financial models can help project several types of risks, including:

• Cash flow risk
• Cash flow over project life risk
• Model risk
• Repayment risk
• Accounting risk
• Equity risk
• Credit risk

So, how do you use financial models to determine the extent of these risks? Let’s use the example of cash flow risk.

Every financial model has a section that projects cash flows over the life of a project. It will help you identify any potential problems in cash flow and determine the probability of problems occurring.

Financial models also include sensitivity analyses, which can be used to project the impact of market fluctuations on a project. It helps you understand how different scenarios may affect your risk profile.

Suppose the ‘stress scenarios’ you’ve included in your financial models are:

• Changing market conditions
• A shift in consumer behavior
• Interest rate changes

The stress scenario analyzes in your financial model would have calculated the reduced cash flow you can expect in these situations. For example, how would the cash flow change if the interest rate went from 5% to 8%?

This information can be used to understand the magnitude of potential cash flow risk and devise strategies to mitigate it. You can use this data to determine if you’ll face a risk of running out of investment or being able to pay off the loan.

Which Sections of the Financial Models Can Help in Risk Assessment?

When using financial models for risk assessment, you must focus immensely on the following sections:

• Cash Flow Analysis: This section will project cash flow over the life of the project, which can help you identify potential problems with cash flow.
• Sensitivity Analysis: It provides insight into how different scenarios can affect the risk profile of a project. These scenarios can range from changes in the interest rate to changes in market conditions.
• Risk Matrix: The matrix provides an overall assessment of the risks associated with a project. It is a culmination of the data from the cash flow and sensitivity analysis sections, which can be used to make informed decisions.
• Assumptions and Drivers: Financial models also include assumptions and drivers that can help you understand the impact of factors such as inflation, regulatory changes, etc., on a project.

How to Structure a Financial Model for Risk Projection?

The first step in structuring a financial model for risk projection is to collect historical data. You should have at least three years of financial data to make an accurate assessment.

Then, use this data to calculate metrics and ratios. These may differ across businesses. For example, a SaaS company may focus on customer churn, while a manufacturing company will look at inventory management.

After that, input the necessary assumptions into the model. Assumptions can include interest rates, sales growth, inflation, and more. Keep in mind that your assumptions should be data-driven and informed.

Now, you can use this data for a forecast. It could include projections of sales, cash flows, profits, and more. Finally, you can use the projected data to identify risks that may arise over the lifetime of the project. These could include cash flow risk, repayment risk, and more.

Financial models can help you assess both long-term and short-term risks, allowing you to make informed decisions. However, you can only project risks accurately if the financial model is built properly.

Make sure to use accurate data and assumptions to get the most out of your financial models for risk assessment. Alternatively, leave financial modeling to the pros.

Project Financial Risks With Our Financial Models

Every startup has a different story. The risks that affect one might not be the same for another. That’s why you need a financial model tailored to your business.

At Numberly, we design bespoke financial models for startup founders who want to pitch for fundraising, forecast cash flow, and assess financial risks. Our professional analysts will build a model that accurately reflects your business and its future prospects. We use industry-standard techniques and approaches to ensure accuracy and reliability.

Most importantly, we use dynamic assumptions to ensure the financial model can keep up with the changes in your business. Take a walk-through of our financial models and get in touch to learn more.