Financial modelling is the process of creating financial statements for a business. Every business creates financial models to show growth revenue, future costs, assets, liabilities, etc. It is like a mathematical representation of a company’s financial health.
Financial models are quite important in decision-making. They can be used to calculate the impact of a future event or decision.
Uses of Financial Models
Different types of financial models serve different purposes. Here are some core uses of financial models:
You can use financial models to evaluate investment opportunities by forecasting future cash flows, assessing risks, and estimating returns.
Valuation & Fair Value Estimation
There are specific financial models like Comparable Company Analysis (CCA) or Discounted Cash Flow (DCF) which are used to estimate the value of assets and companies.
Financial Planning & Budgeting
By projecting revenue, cash flows and expenses for future projects, financial models help in budgeting and financial planning.
Financial models help in conducting sensitivity analysis and stress testing to assess risks and evaluate the impact of uncertain factors on financial outcomes.
Financial models are used by executives and financial analysts for decision-making.
8 Types of Financial Models
Three Statements Model
The Three Statement model is an integration of three vital statements – the income statement, cash flow statement and balance sheet.
- Income Statement – The income statement is prepared annually or quarterly. It displays the company’s net income, expenses and profits in that particular time period.
- Cash Flow Statement – A comprehensive statement of cash inflows and cash outflows.
- Balance Sheet – Reflects business assets, liabilities, and funding sources.
Financial analysts can use this financial model to project a company’s performance. It helps predict future performance by analyzing past data and making assumptions. For example, a retail company can use this model to estimate sales growth, track inventory, and plan expenses.
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Discounted Cash Flow Model
The purpose of the DCF model is to do a proper valuation of a business, project or any type of investment. It is built upon the three-statement model as it calculates the time value of money by discounting projected free cash flows to the present date. Discounted Cash Flow Model helps determine the worth of investment by considering the time value of money. The cash flows can be levered or unleveled.
DCF model can help determine whether the company’s current market value is overvalued or undervalued. It s commonly used in equity research and capital markets. When evaluating the impact of strategic initiatives, the DCF model can be used in decision-making.
Mergers & Acquisition Model
As the name suggested, M&A model evaluates the financial feasibility and consequences of merging two companies. For instance, let’s consider a scenario where a larger corporation plans to acquire a tech startup. The M&A model would analyze factors like projected revenue growth, potential cost savings from acquisition and other acquisition costs. It can help you determine earnings per share, the effect on cash flows and the overall return on investment.
The merger and acquisition model helps determine the value of a company you plan to acquire and also the total acquisition amount you must pay.
Leveraged Buyout Model
The LBO model is an advanced and challenging type of financial model. It is commonly used by equity and investment banking analysts.
This model assesses the financial viability of acquiring a company using debt. By evaluating the risks associated, investors can estimate the potential returns. Take the case of a private equity firm considering LBO of a small-size manufacturing firm. The private equity firm would analyze factors like projected cash flows, capital structure, debt financing costs, and exit strategies. The LBO model would help estimate the potential return on investment and assess the company’s ability to generate sufficient cash flows to service the debt. By conducting sensitivity analysis and stress testing, decision-makers can evaluate different scenarios and make informed decisions regarding the LBO opportunity.
The abbreviation of IPO is Initial Public Offering. IPO is the process of listing a company on the stock market and making its share available to the general public. Before listing, the company has to figure out various things like the offer price to set and the expenditures related to the IPO. It has to also consider the dilution effect on existing shareholders and how the IPO may affect the company’s earnings per share.
By analyzing all these factors, companies can estimate the amount of funds they can raise via IPO. The IPO model is then exclusively used to make decisions about the timing of the IPO, the price to be set and the structure of the initial public offering.
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Comparable Company Analysis (CCA)
Comparable company analysis compares your company with a similar other company in the same industry. It can even be your competitor. The purpose of this comparison is to determine the value of your company. Various things like revenue, profitability and valuation multiples of comparable companies are considered.
By analyzing these factors, the CCA model helps in estimating the fair value of the company being evaluated. For example, if assessing a software company, the CCA model would compare its financial metrics to other software companies with similar business models and market capitalizations. This model provides valuable insights for investors, analysts, and companies looking to understand the relative value and positioning of a company within its industry.
Option Pricing Model
This is a mathematical model that computes the value of an option. Black Scholes model and Binomial pricing model are the two types of option pricing model. The most widely used option pricing model is the Black-Scholes model.
While computing the fair value of an option, factors like current price, strike price, time to expiration, risk-free interest rate and volatility are considered. This model is commonly used by traders and investors to find the potential profitability of options. It helps in investment decision-making and identifying potential arbitrage opportunities.
Sum of Parts Model
In the Sum of Parts model, the total value of a company is computed by separately valuing its individual business segments. This model is frequently used by conglomerate businesses like Reliance, Adani Group and Tata which have business units in various industries.
The SOP model calculates individual segments of business based on their financial performance and growth prospects. The aggregated sum of these individual segments can be added to get an estimate of the total value of the company.
What Is the Need for Financial Models?
Imagine starting your own business with an investment of 1L (1 lakh). As your business grows, you face important decisions about its value and future prospects.
To evaluate its performance, the discounted cash flow (DCF) model helps estimate future cash flows and determine its present value. As your business flourishes further, you consider expansion through mergers and acquisitions (M&A), the M&A model assesses the impact of acquisition and helps you make a strategic decision regarding an acquisition.
Now, you reach another pivotal milestone and decide to take your business public through an initial public offering (IPO). The IPO model would help in deciding the optimal offer price for shares and estimating the amount to be raised.
As your business evolves further and you venture into different industries, the Sum of Parts (SOP) model would be effective in evaluating the individual valuation of each unit and helping you make strategic decisions on investments, divestments, or restructuring. Lastly, the comparable company analysis (CCA) model lets you compare your business’s financial metrics to industry peers, gauging relative value and identifying areas for improvement.
In this way, various types of financial models help you at various stages of your business in driving growth, evaluating your finances and maximizing the potential of your business.
Also Read – Scope of Financial modeling
How Can I Learn Financial Modeling?
If you aspire to build a career in the world of finance, equity or investment banking, learning financial modelling can be invaluable. Here are some generic tips to get you started:
Learn Excel Skills – Excel is a fundamental tool for financial modeling. Invest time in learning and practising Excel functions, formulas, and shortcuts to efficiently build and manipulate financial models.
Understanding of Financial Concepts – Get yourself familiar with financial jargon like valuation techniques, cash flow analysis, financial statements, balance sheets, IPO, and much more. Knowledge of all these terms will serve as a foundation for understanding financial modeling in detail.
Practice with Real-world Examples: Gain hands-on experience by working on real-world financial modeling examples. Analyze case studies, industry reports, and financial statements to build models that reflect actual business scenarios.
Financial Modeling Course by IMS Proschool
IMS Proschool offers a comprehensive Financial Modeling course designed to equip learners with practical skills and industry-relevant knowledge. The course covers essential topics such as financial statement analysis, forecasting, valuation techniques, and scenario analysis.
Key features of the Financial Modeling course by IMS Proschool include:
- Hands-on experience with real-world case studies
- Industry veterans who take the role of faculty and guide students in all the subjects
- Industry aligned curriculum, you acquire skills and knowledge that is of high demand in the industry
- Placement assistance to help you kickstart your career with job opportunities in reputed organisations.
What are the tools used for Financial Modelling?
MS Excel is the most popular tool used for creating financial models. It’s easy to audit, easy to use and equipped with all the functions needed to create financial models. There are also other financial modelling software like Mosaic or MATLAB that can be used.
What level of expertise is required to create or use financial models?
For creating and using financial models, you need to have basic expertise in finance, accounting and proficiency in using Excel and similar other tools. There are also user-friendly financial modelling tools available that can be utilized by individuals with less technical expertise.
Can financial models be customized for specific business needs?
Yes, financial models can be customized to suit specific business requirements. Depending on the complexity and uniqueness of the business, models can be tailored to include specific revenue drivers, cost structures, industry-specific metrics, or additional analysis relevant to the business’s operations and objectives.
Which are the useful financial models for startups?
Useful financial models for startups include the Three Statement Model for projecting financials, the Cash Flow Forecasting Model for managing cash flows, and the Valuation Model for estimating the startup’s value based on the growth potential and industry benchmarks.