There are two broad ways to think about financial models: Operating Models and Transactional Models.
Think of owning an old Porsche. The operating model is the blueprint for upgrades. You might tune the engine, change the color, or even add a spoiler (please don’t). Each change must be carefully evaluated to improve performance and preserve value. These are small, incremental improvements you can test as you go.
The transactional model is the due diligence you do before buying the car. You are assuming all the risk at once, so you need to understand its history, the care it has received, and whether the value will hold up in the future. Just as importantly, you need to think about how you are paying for it. Are you financing the purchase or paying cash? That choice changes the risk profile dramatically even though the car itself has not changed.
What does that mean in a business context? Let’s break it down.
Operating Models: Learning by Building
An operating model is a highly detailed, three-statement model focused on a company’s key profitability and growth drivers.
Most people assume the purpose of a financial model is to predict the future. But that’s impossible. The real goal is to build a clear understanding of the company’s past and present. With that foundation, you can test assumptions and explore a range of possible outcomes.
If you can properly build a detailed three-statement operating model, including the income statement, balance sheet, and cash flow statement, you’ll learn a lot about the business in the process.
Why? Because operating models encourage an exploration of the details driving results. You might build revenue schedules by customer or product, analyze working capital by line item, or allocate cost at the employee level. Linking these schedules back to the three-statement framework demonstrates how changes in these individual parts of the business affect overall profitability and cash flow.
The deeper you go, the more you learn. And once you have that foundation, the question becomes: what do you want to do with it?
Testing Assumptions & Influencing Change
Every business has a handful of key drivers that matter most. Some of these, like gross margin, will be relatively universal and others will be highly bespoke. A working operating model helps you identify them and understand the impact of potential changes.
When trying to craft a strategy or value creation plan for a business, this is incredibly useful. The model helps you prioritize areas of focus.
But here’s the trap: People assume that if the model is perfect, the future will unfold exactly like the Excel output. It almost never does.
Businesses run on people, not formulas. And people are unpredictable.
The best insights appear after you act on your assumptions, see the real-world impact, and then adjust.
You won’t always get it right. But if you pair a solid analytical foundation with speed and flexibility, you can iterate toward success. Smaller incremental change reduces the risk profile of each decision, which means that you don’t always have to be right; you have to be willing to adjust.
The best decision-making formula, in my opinion, looks like this:
Thorough Analysis >> Speed to Decision >> Willingness to Change Your Mind >> Repeat
Transactional Models: Managing Risk and Return
When we talk about transactional models, it’s typically in reference to an LBO model (leveraged buyout model).
Here, the focus shifts. Operating models help improve performance over time. Transactional models focus on risk and return, often in the context of a new capital structure. You want to know how an investment can grow, but also how much pain it can withstand and survive.
Perfect projections don’t exist. You’ve likely heard it before, but the only thing certain about a projection is that it will be wrong.
And the upside story is usually a simple one. It can be modeled on the back of a napkin. Revenue grows, margins expand and everyone makes money. What often makes or breaks an investment, though, is the variance between upside and downside cases and how different capital structures perform across them.
This is further complicated by differences in upside and downside modeling. As revenue increases or decreases, a basic financial model will add or subtract the associated resources required like clockwork.
But humans don’t operate this way when conditions deteriorate. People can be slow to act or irrational when confronted with loss. When revenue plummets, hard decisions must be made, and this generally takes time to work through.
There are also model mechanics that break down under stress. Tie inventory levels to sales, and a decline in revenue will produce cash flow in Excel that never materializes in the real world where inventory sits idle.
I’ve lived this. Large layoffs are brutal for both the business and the people leading it. Assuming they will happen instantly in a crisis is naïve and dangerous.
That’s why thoughtful downside modeling matters. How flexible is the business when pressure hits? How long can it survive before breaching debt covenants? How quickly will the leaders react to declining cash balances?
Here’s the key insight: the more pain an investment can endure, which is generally a function of purchase price and capital structure, the greater the margin of safety. And the greater the margin of safety, the more time and opportunity you have to course correct under adverse conditions.
That’s what a great transactional model reveals.
People Matter Most
All that said, financial models are useless if you don’t understand the culture of a company and the people who make it run.
A model can show you where value should be created, but people determine whether it will be created. They make the decisions, adapt to pressure, and carry the weight of both growth and decline.
Models can’t capture how a management team will respond to uncertainty or whether a company’s culture will embrace change or resist it. Those human factors drive real outcomes.
So yes, build the model. Build several if you need to. Make them detailed. Use them to learn the business, test assumptions, and manage risk. But never forget: it is people who turn numbers into reality.
The Three-Statement Framework
Both models require a solid grasp of the three-statement framework. Once you understand the core relationships between the income statement, balance sheet, and cash flow statement, adding detail for an operating model becomes straightforward. An LBO model is essentially the same framework adjusted to include a transaction and exit analysis.
That’s why the content on ASimpleModel.com focuses heavily on the three financial statements and the three-statement model. Please see the video below for an explanation of how this content is taught at ASM.