Financial modeling entails interpreting the number of features in company operations. Financial modelling is the task of building an abstract representation, called financial models, of a real-world financial situation. It is a mathematical model that represents the best scenario of performance for certain investment or business.
Financial models are created to project the cost, revenue and profits of a real-world situation. Depending on who is using them, they might help an executive manage new projects or anticipate economic change. Since financial analysts often work with these models, it's important for them to be clear and correct with their projections.
Common types of financial models are the Initial Public Offering (IPO) Model and Leveraged Buyout (LBO) Model.
What is financial modeling?
Financial modelling is the process by which a firm constructs a financial representation of some, or all, aspects of the firm or given security. The model is usually characterised by performing calculations and makes recommendations based on that information. The model may also summarize particular events for the end-user and provide direction regarding possible actions or alternatives.
Objectives of Financial Modeling:
Financial models help projects and analyze the financial performance of companies, useful in various fields. These financial models are primarily used by finance professionals and trustees to support decision-making and prepare for projects.
The following are the objectives of creating aa financial model:
- Valuing a business
- Asking for funding
- Growing the company
- Buying or selling assets and other businesses
- Allocating capital wisely
- Planning your budget
- Forecasting trends
Financial models require a set of assumptions. For example, one common line item is sales growth. Sales growth is the increase or decrease in revenue from one quarter to the next expressed as a percentage of quarterly revenue.
Ten golden points to follow for Financial modelling:
- Historical results and assumptions
- Start the income statement
- Start the balance sheet
- Build the supporting schedules
- Complete the income statement and balance sheet
- Build the cash flow statement
- Perform the Discounted Cash Flow (DCF) analysis
- Add sensitivity analysis and scenarios
- Build charts and graphs
- Stress test and audit the model
Project finance models
To evaluate the feasibility of a project, the project finance model can be used to determine the structure and capital of the project. In order for a project to qualify as “financially feasible” based on this model, it must have sufficient cash flow from operations over its lifetime to cover all operating expenses plus debt-servicing obligations.
The debt repayments associated with loans are an inevitable part of project finance models, since projects usually last longer than a year and lenders need to ensure the company can generate enough profit to cover the loan payments. In other words, the project finance model is used as a financial model when the company needs to assess the economic feasibility of the project.
Metrics such as the debt service cover ratio can be a good way to measure project risk and calculate an interest rate offered by a lender.
Right at the start of the project, the DSCR and other metrics are agreed upon between the lender and borrower such that the ratio must not go below a certain number.
Pricing models
This class of financial models is best used to establish the price for products.
The cost of production sets the lower limit for the price while consumer perception about a product or service dictates where it goes. A company uses four general pricing approaches cost-based pricing, value-based pricing, value-based pricing and competitive-based pricing.
Input to a pricing model is the price, and output is profitability. A top-level way to create and refine models: First create a profit-and-loss statement for your product or business at current prices. Break out these costs into fixed and variable expenses up to some level of detail that makes sense for the specific situation.
Units × Price = Revenue
Revenue – Expenses = Profit
Financial models can range in complexity, with some requiring many calculations or tabs to create a single structure. Sensitivity analysis is advised when using goal seek or data table for such structures.
Integrated financial statement models
This category of the model is also known as a three-way financial model.
The following are the three types of financial statements included in an integrated model:
Income Statement, also known as Profit and Loss statement (P&L)
Cash flow statement
Balance sheet
When constructing financial models, not every category must contain all three types of financial statements. However, many do and these are referred to as integrated reports.
When the financial statements in an integrated financial model are linked, it becomes very important for all related statements to change in response to adjustments made.
Valuation models: This category of financial models values assets or businesses for the purpose of joint ventures, refinancing, contract bids, acquisitions, or other kinds of transactions or deals.
When valuing a company as a going concern there are three main valuation methods used by industry practitioners:
- DCF (Discounted Cash Flow) analysis
- Comparable company analysis
- Precedent transactions
These are the most common methods of valuation used in financial modeling (investment banking, equity research, private equity) and areas of finance. A common example is an Initial Public Offering Model or a Leveraged Buyout Model.
Reporting models
Financial models condense the history of revenue, expenses, or financial statements.
Some schools of thought argue that these financial models are not valid, because they look at what happened in the past. However, some experts say that the principles and design behind these financial models are identical to other major financial models.
Reporting models are often used to produce reports that include forecasts and rolling forecasts, which in turn rely on assumptions and other drivers.
The 10 most popular types of Financial modeling:
Three-Statement Finance Model
A three-statement model links the income statement, balance sheet, and cash flow statement into one dynamically connected financial model. These fundamental models are used to build advanced financial models such as discounted cash flow DCF models, merger models, leveraged buyout LBO models and various other types of financial models.
It falls under both categories of financial models: reporting and integrated financial statement models.
Discounted Cash Flow (DCF) Model
These sorts of financial models are categorized as Valuation models and typically used in equity research or other areas of the capital markets.
The DCF model is a type of financial forecast that values a company. Defined as the Net Present Value (NPV) discounted back to today’s value, it uses an unlevered free cash flow estimate and forecasts - the NPV is considered a very accurate way to measure the intrinsic value of a firm.
The basic building block of a discounted cash flow (DCF) model is the three-statement financial model. This link the company's cash flows together takes it to the WACC method and discounts them to today's value.
Merger Model (M&A)
The M&A model also falls under the Valuation category of financial models.
This type of financial modeling is more complicated and often used with mergers and acquisitions to assess the pro forma accretion/dilution. Typically just one tab model for each company is used, where consolidation is represented as Company A + Company B = Merged Co. The level of complexity varies.
Initial Public Offering (IPO) Model
The IPO model is also a Valuation model.
The financial models drafted by investment bankers to determine the value of their company before it goes public are important for helping investors benefit from stocks that trade well on secondary markets. The IPO discount is used in order to limit fluctuations and guarantee good performance after going public.
Leveraged Buyout (LBO) Model
Leveraged buyouts enable private equity firms to purchase a company using debt. These deals are typically arranged when outsiders provide as much debt as they can at up to 70 or 80% of the purchase price while funding the remainder with their own money.
LBOs are detailed and complex financial models that require a variety of debt schedules. They originate from the private equity world, but can also be found in banking when dealing with client financing packages.
Some of the Parts Model
One type of financial model in the Valuation category is developed by taking into account a number of DCF models and adding them together. The value of any Sundry Factors, such as Business Unit A, Business Unit B, investments C, liabilities D to get the NAV for the company.
Consolidation Model
The Consolidation Model is a Reporting Model. It combines several business units into one model for financial modelling and further analysis. Each unit typically has its own tab, with a consolidation tab that simply sums up the other cells in the table, like adding two divisions together to get one new consolidated division.
Budget Model
The budget model is used to create projections for the next few years of income and expenditures in financial planning and analysis (FP&A), typically over a one-year, three-year or five-year timeline. The budget relies heavily on monthly and quarterly figures from an organization's gross profit margins and expense statements.
Forecasting Model
Both the budget and forecasting models are used in FP&A to come up with a forecast that compares well. Though they come from different categories of financial models, they are both common. Sometimes the budget and forecast models are shown in one combined workbook, but they can be in different worksheets.
Option Pricing Model
As the name suggests, this model falls under Pricing models. The two most popular ones are Binomial Tree and Black-Sholes which is a financial model based on math rather than specific standards.