In the fast-paced and complex world of finance, the ability to make reasonable predictions and informed decisions sets a good organization apart from the crowd.
To achieve that, Financial models serve as powerful tools that enable you to make better decisions based on analyzed data and forecasted future outcomes with utmost precision.
Financial models involve constructing a framework that captures the relationships between various financial variables and uses them to make predictions, perform analyses, and simulate scenarios. These models range from simple spreadsheet-based calculations to complex algorithms and statistical models.
Types of Financial Models To Master Decision-Making
Usually, the finance models are constructed according to the different circumstances and unique needs of the firm.
However, we have compiled some of the most relevant and fundamental types of financial models to make accurate data-driven decisions for your organization.
1. Three-Statement Model
A 3-Statement Model (also known as an Integrated Financial Statement Model) combines three core financial statements:
- Income statement
- Balance sheet
- Cash flow statement
These statements provide a comprehensive view of a company’s operations, financial position, and cash flows over a specified period, typically a year.
The Income Statement includes the following:
- Revenue: Sales generated by the company
- Cost of Goods Sold (COGS): Direct costs associated with producing goods or delivering services.
- Gross Profit: Revenue minus COGS.
- Operating Expenses: Overhead costs incurred in the day-to-day operations.
The Balance Sheet provides a snapshot of a company’s financial position at a specific point in time.
The Cash Flow Statement tracks the flow of cash in and out of a company during a specific period.
- Operating Cash Flow
- Investing Cash Flow
- Financing Cash Flow
- Net Change in Cash
All these statements are interconnected, and changes in one statement impact the others. The objective of a 3-Statement Model is to provide a comprehensive view of your organization’s financial performance.
2. Discounted-Cash Flow Model
The Discounted Cash Flow (DCF) model is used to estimate the intrinsic value of an investment.
The DCF model is widely preferred as it provides a comprehensive and objective assessment of an investment’s value, considering the time value of money.
Following is the process involved in the DCF Model –
- Cash Flow Projection: The first step is to project the future cash flow expected to be generated by the investment. The projections are typically made over a specific time period (i.e. 5 years or more).
- Determine the Discount Rate: The next step is determining the appropriate discount rate. It is usually based on factors such as the company’s borrowing costs, beta, risk free rate and equity risk premium.
- Discounting Cash Flows: Using the discount rate, the projected future cash flows are discounted to their present value.
- Terminal Value: The DCF model also considers the terminal value, which is the value of the investment beyond the projected period.
- Calculating the Present Value: The discounted cash flow and the terminal value is then summed to derive the total present value of investments. This makes the estimated intrinsic value of the asset at the current time.
- Sensitivity Analysis and Interpretation: Lastly, sensitivity analysis is conducted to assess the impact of changes in critical assumptions such as cash flow growth rates or discount rates.
DCF is a great model for financial valuation but is often misinterpreted due to the complexities involved.
If you want to master the DCF valuation and other financial models to gain a competitive edge and achieve long-term business success, check out our Finance Modeling Courses.
3. Merger and Acquisition Model (M&A)
A Merger and Acquisition Model comes into play when there’s a need to evaluate the dilution of a merger or an acquisition.
It helps in assessing the strategic and financial viability of the transaction, estimating the synergies, and determining the fair value of the target company.
Usually, this financial model is used in investment banking and corporate development niches.
It is an advanced variation of the financial modeling, as it requires making adjustments to create a Pro Forma closing balance sheet, including the terms of the deal, conducting sensitivity analysis, and determining the expected impact on the valuation.
4. Credit-Rating Model
A credit rating model is usually used by financial institutions to assess the creditworthiness of individuals, companies, or financial instruments.
It assigns a rating or score that reflects the likelihood of default or the risk of credit losses.
The model considers various factors such as financial statements, credit history, industry dynamics, and macroeconomic conditions to determine the borrower’s creditworthiness.
The Credit-Rating Model can be used for the following purposes:
- Credit Risk Assessment
- Loan underwriting
- Risk Management
- Portfolio Management
- Pricing and Risk-based Pricing
- Regulatory Compliance
5. Sensitivity and Scenario Analysis Model
Sensitivity analysis models assess how changes in key variables, such as interest rates or input costs, impact financial outcomes.
By evaluating these variables, finance professionals can identify the sensitivity of financial models and calculate the potential risks and opportunities.
Experts do this type of modeling, and they link the model so that it becomes feasible to assess the impact of changes in input variables on the output.
The primary purpose of sensitivity analysis is to quantify and evaluate the uncertainties and risks associated with decision-making.
It also provides insights into the factors that significantly influence the results of a model and helps in making informed decisions by considering various scenarios with their potential outcomes. Sensitivity analysis is precious in situations where the accuracy and reliability of model predictions are essential for effective decision-making.
6. Comparable Analysis Model
Also known as relative valuation, the comparable analysis model is generally used to calculate a company’s value.
This is done by comparing a company to similar publicly traded companies in the same industry. The analysis model helps determine the fair value of a company’s stock based on the market value of other similar companies.
This model typically works in the following way:
- Choosing comparable companies – This step helps identify a set of companies that operate in the same industry and have similar characteristics as the business being analyzed. Factors like growth rate, business model, size, and target market are analyzed.
- Gathering financial data – The next step is to collect the financial data of the company that’s being analyzed. This includes key financial statements like balance sheets, income, and cash flow statements.
- Analyzing financial ratios – A variety of valuation multiples are calculated and compared between a target company and other comparable companies. In this case, ratios like EV-to-Sales, EV-to-EBITDA, EV-to-EBIT and P/E multiples are calculated.
- Valuation – Depending on the calculation of valuation multiples, an appropriate average multiple or a range is determined for the target company.
The Comparable Analysis Model also has its limitations. The accuracy of this model depends on the selection of the companies you want to evaluate and the quality of the financial data that you use.
7. LBO Model
A Leveraged Buyout (or LBO) model is used to evaluate the acquisition of a company using an amount of debt financing.
In an LBO model, a private equity firm or a group of investors acquires a company with the help of equity investment and borrowed funds. This model helps analyze the financial potential of a company.
Here’s an overview of how an LBO model typically works:
- Acquisition Structure – This step determines the acquisition structure which includes the purchase price, the amount of equity investment, and the amount of debt to be borrowed.
- Financing assumptions – This includes the assumptions about debt financing which includes the interest rate on the debt, the repayment terms, and any extra transaction costs. These assumptions help in calculating the debt service payments and determining the cash flow available for the repayment of the debt.
- Operating assumptions – This includes a company’s future financial performance which includes revenue growth rates, operating expenses, and capital expenditures. This helps understand historical financial data, management projections, and industry benchmarks.
- Exit Analysis – Exit analysis is an important part of the LBO model as it calculates the potential proceeds that could be raised from selling a particular company after the end of the holding period. The value is based on multiple valuation factors and techniques.
The LBO model is somewhat of a complex financial model. This means that it requires a great deal of understanding of different financial statements, debt structures, and valuation techniques. Currently, such models are used by investment banks and private equity firms.
Successful financial modeling can help your organization pace its success journey and set you ahead of your competition.
The value of the right, data-driven decisions is incomparable.
However, whether you’re a seasoned finance professional or just starting your career, it is always essential to understand the value of learning from suitable and credible sources like CFI education.
Designed by industry experts, our courses offer a blend of theoretical knowledge and practical application to help you get the most out of your study material.