Companies, investment bankers, and research analysts use different financial models to project how a business or an investment will perform in the future. Let’s understand how Financial Modeling works and take a look at the ten most popular types of financial models used by analysts.
What is Financial Modeling?
A financial model is essentially a representation of a company’s financial situation that tells us about its current and future financial performance. Generally, these models are created using spreadsheets, and they allow businesses, analysts, investors, and other stakeholders to simulate different kinds of financial scenarios. These simulations are based on what the analysts assume, past data, current trends, and numerous other types of inputs.
The process of creating these models is known as Financial Modeling, and it helps companies make informed decisions. Through basic Financial Modeling, companies can evaluate the different parameters of future financial performance of a company, such as how profitable the company can be in the future, the risks involved with new ventures, and how it can use its limited uses efficiently.
Why Financial Modeling is Important
There are many reasons why companies employ financial modelling techniques. Here are some of them:
- Risk is an inherent part of any business. Companies can use Financial Modeling to analyse different scenarios to identify the risks they may encounter in the future. Once the major risks are known, steps can be taken to either avoid, mitigate, or transfer them.
- Past data can be used to predict where a company is headed. Analysis of historical performance can tell decision makers which decisions worked out and which didn’t, so more informed decisions can be made.
- Companies can use models like growth models and cash flow analysis to attract more investors by giving them a clear and detailed representation of their financial health and future potential.
- Financial Modeling can help companies determine their true valuation.
- Decisions driven by data are more informed, objective, and reliable. Financial models enable companies and investors to base their strategies on factual evidence rather than assumptions or intuition.
- Models can be used to forecast changes through scenario analysis. This process simulates different internal and external scenarios to understand how they may affect the company should they happen. For example, a scenario model can help a company understand how increasing interest rates can affect its revenue.
- Effective budgeting is important for any company. Financial models allow businesses to use their resources efficiently through a budget.
Overview of Different Types of Financial Models
Different types of financial models help companies achieve different kinds of objectives. Here are 10 of the most popular financial models:
1. Three-Statement Model
We’ll start with the most basic of all financial models – the three-statement model. As the name suggests, this model comprises of the three fundamental financial statements:
- The income statement – This tells us about a company’s annual or quarterly revenue, cost, and net income. Also known as the profit and loss statement.
- The balance sheet – The balance sheet provides a clear picture of a company’s equity, assets, and liabilities.
- The cash flow statement – Which outlines a company’s cash inflows and outflows during a period.
This model helps analysts understand the relationship between these three statements. When the variables in one statement change, there is an impact on other statements. For example, the profits or losses from the income statement can affect the equity on the balance sheet. The three-income statement model is very useful in determining the financial health of a company and can be used to project future financial performance.
2. Discounted Cash Flow (DCF) Model
This model focuses on the intrinsic valuation of a company, that is, an estimate of a company’s value based on its ability to generate future cash flows. The discounted cash flow model takes into account the time value of money to calculate projected free cash flows that must be discounted back to their present value. This means adjusting future cash flows to reflect their worth today, as money is more valuable now than it is in the future. Once discounted, these values are added together to calculate the company’s implied valuation.
3. Merger Model (M&A Model)
There are financial implications when companies merge or acquire other companies. A number of financial factors must be considered, and the merger and acquisition (M&A) model helps analyse these complexities. It determines how the financial statement of the acquiring company or the merger will be impacted, and what the earnings per share will look like in the future after the deal is completed. Based on the value of the EPS, the deal can be either accretive (the EPS increases) or dilutive (the EPS decreases).
4. Initial Public Offering (IPO) Model
When a company goes public, it launches an Initial Public Offering or IPO to sell shares to the public for the first time. Of course, going public has a significant impact on a company, and the initial public offering model is used to analyse the financial implications of this process. It helps determine:
- The company’s valuation.
- Its share price (How much the investors will be willing to pay)
- The potential future performance in the stock market.
- How going public will affect the company’s financial structure.
Setting the share price is a crucial decision. The company must raise enough capital and at the same time make the share attractive to investors. This model helps them do just that.
5. Leveraged Buyout (LBO) Model
Acquiring a business can be a very profitable investment for a company. However, it’s not always possible to finance the acquisition using only the acquirer’s available cash. This is where leveraged buyouts become an attractive option. Through this process, the acquiring company uses a combination of debt and equity to finance the purchase, with the majority of the funding coming from debt. The leveraged buyout model helps companies determine how much debt they can take and whether or not the profits of the company they acquire are enough to support the repayment of the debt. These models are complex and not very commonly used outside of private equity firms.
6. Budget Model
This model is generally used by financial planning and analysis professionals to create budgets for the upcoming years. The budget model focuses heavily on the income statement and allows analysts to allocate the company’s resources efficiently. Companies use this model to estimate their revenues and costs, set their financial goals, and measure performance against these goals. It can be used for corporate budgeting (planning annual budgets) or project budgeting (budgets with special objectives, time frames, and financial constraints).
7. Forecasting Model
This is another model used primarily by financial planning and analysis professionals. The forecasting model uses statistical methods such as time series analysis and regression analysis to predict the future financial performance of the company or an investment. It uses past data and market trends to give decision makers a glimpse of the future, so they can set or adjust their financial strategies accordingly. For example, it can help a company determine how well it is performing compared to its budgeted goals. It can also enable businesses to project future revenues, expenses, or cash flows.
8. Option Pricing Model
This model is a purely mathematical tool that can be used to calculate the fair value of options. Options are financial derivatives which give the holder the right, however, not the obligation, to buy or sell an asset at a predetermined price. Through the option pricing model, investors can assess whether an option is fairly priced based on various factors such as the underlying asset’s price, time until expiration, volatility, interest rates, strike price, risk free rate, and type of option. There are three major types of option pricing models:
- The Black-Scholes model
- The binomial model
- Monte Carlo SImulation
The option pricing model is generally used by traders to estimate the value of options.
9. Consolidation Model
Companies with subsidiaries are often required by regulators to report consolidated statements, where the financial data of the parent company is combined with all its subsidiaries and divisions to form a single set of financial statements. The consolidation model is used to combine these financials into one extensive report, which gives a clear view of the company’s financial health as a whole.
10. Sensitivity Analysis Model
The sensitivity analysis model is a model that is applied to other financial models. It is not a standalone financial model on its own, but rather it is a tool used to test how changes in key input variables affect the output of a financial model, such as the discounted cash flow model or the three income statement model. The ‘sensitivity’ in the name refers to testing how sensitive the results are to changes in assumptions or variables.
For example, in a DCF model, you can change inputs like revenue growth, discount rates, or profit margins to see how they impact the company’s valuation. This allows analysts to understand exactly which variables have the biggest effect on a model’s output and helps them identify the key risks and opportunities.
How to Choose the Right Financial Model
There are many financial models to choose from, but it’s important to note that each model serves a different purpose. Analysts ask themselves a number of key questions before making a decision. Here are a few of them:
- What is the purpose of the analysis?
Does the company need to make forecasts, estimate whether their potential acquisition can be profitable, or assess its value?
- What kind of data is available?
Not all models require the same kind of data. Some, such as forecasting models, need to be fed a large amount of historical data to give meaningful results. On the other hand, some models can function on assumptions and current data.
- What is the industry standard?
Different industries apply different models to assess financial performance, make investment decisions, and evaluate business strategies. The choice of model often depends largely on the specific industry.
- What kind of software and tools are available?
Many models can easily run on Excel, however, there are some advanced models that require specialised software to function.
- What is the time frame?
To determine if the analysis is focused on short-term or long-term financial results.
Examples of Financial Models
Here are a few Financial Modeling examples to give you a glimpse into their potential applications across different scenarios:
- Forecasting models can be used by a retail company to predict future sales based on historical data, market trends, and seasonal patterns. For example, an electronics store can use models to forecast their sales during Diwali to anticipate customer demand and keep themselves stocked accordingly.
- If a company wants to buy out a small rival company, it can use the merger and acquisitions model to understand how its earnings per share will be affected after the deal is made.
- Continuing from the previous example, if the company decides to borrow money to finance the acquisition, it can use the leveraged buyout model to determine whether or not the profits of the acquired company can effectively repay the debt taken.
- A company considering going public can use the initial public offering model to estimate its future value, set an attractive, yet realistic share price, and assess investor interest.
Conclusion
Financial Modeling is the process of creating a simplified representation of a company’s financial performance. It uses past data, assumptions, and financial metrics that help simulate various scenarios and results. Financial models can also be divided into two parts – Internal models and external models. Models such as the three-statement model, discounted cash flow model, consolidation model, and budget model are considered a part of internal Financial Modeling, whereas the option pricing model, leveraged buyout model, initial public offering model, and merger model are considered external financial models.
Different types of financial models serve different purposes, but ultimately, their goal is to guide companies to make more informed decisions. They can be used for a variety of goals, such as assessing the potential for an IPO, evaluating a merger or acquisition, or forecasting future revenues.
