In this article, we discussed the meaning of financial modeling, we also talked about the different types of financial modeling
Definition
Financial modeling is the process of creating a summary of a company’s expenses and earnings in the form of a spreadsheet that can be used to calculate the impact of a future event or decision. A financial model has many uses for company executives.
Top Best Types of Financial Models
Three-Statement Model
A three-statement model links your company’s main financial statements through a series of formulas in Excel:
Income Statement: shows the company’s revenues, expenses and net income over a specific period, typically a quarter or a year
Balance Sheet: provides a snapshot of the company’s financial position at the end of the reporting period, detailing its assets, liabilities and equity
Cash Flow Statement: outlines the company’s cash inflows and outflows across operating, investing and financing activities during the same period.
Sum of the Parts Model
The sum of the parts model helps you understand the total value of a business that has multiple divisions or operates in different industries, like Amazon or General Electric for example.
The SOTP model breaks down the company into its individual components, valuing each one separately and then adding them up to get the total value.
Valuing each part individually gives a clearer picture of the business’s overall value and identifies potential areas of strength or weakness.
This financial modeling and valuation technique is also useful for:
Assessing the potential value of splitting parts of a business into independent entities
Deciding whether it’s worth buying or selling a part of a diversified business
Helping investors understand the underlying value of a diversified business
Discounted Cash Flow Model
The Discounted Cash Flow (DCF) model estimates the intrinsic value of a business, asset or investment by discounting its expected future cash flows to the present value.
This approach is based on the principle that a dollar today is worth more than a dollar in the future, due to factors like inflation, risk and the opportunity cost of capital.
The DCF model is popular for valuing companies, projects, or assets. It helps investors and analysts assess investment opportunities. This includes:
Evaluating the potential return on investment (ROI) for various opportunities
Deciding whether to proceed with capital projects, like expanding operations
Using cash flow projections from different sources to inform strategic decisions
Creating forecasts and presentations that explain the company’s value to investors
Testing “what-if” scenarios to understand how changes in key factors affect valuation
Preparing financial disclosures that comply with regulatory requirements.
Consolidation Model
The Consolidation Model combines a parent company’s financial statements with those of its subsidiaries into a single set of statements.
These consolidated financial statements give a 360-degree view of the financial health and performance of the parent company and its subsidiaries as if they were a single entity.
Publicly traded companies, conglomerates or companies with significant ownership stakes in other entities use this method to:
Prepare financial reports, tax filings and regulatory compliance
Give investors and creditors a complete view of the entire business group
Help management understand the company’s performance and make strategic decisions
Budget Model
A budget model helps FP&A analysts estimate the company’s revenues and expenses, allocate resources, and set realistic financial goals. It outlines how resources will be allocated over a certain period to meet financial goals and operational requirements.
This financial modeling tool is used for:
Corporate Budgeting: For businesses planning their annual budgets
Project Budgeting: For projects with specific timelines and financial constraints (like construction projects, for instance)
How the Budgeting Model Works
The budgeting model varies depending on the context, but the core principles remain consistent: planning, tracking, adjusting and evaluating spend. It includes key components like:
- Budgeted balance sheet (assets, liabilities and equity)
- Income statement (projected revenues, expenses forecasts and net income)
- Cash flow projections (the expected flow of cash in and out of the organization)
- Contingencies and reserves (extra funds set aside for miscellaneous and emergencies)
The budgeting process requires you to identify all sources of income, categorize expenses, establish your budget structure and track your spending.
Initial Public Offering Model
An Initial Public Offering (IPO) model estimates the value of a company preparing to go public and helps stakeholders understand the potential outcomes of this move.
Financial analysts use the IPO model to conduct valuation analyses. They compare the company to its industry peers and provide recommendations regarding the IPO investment opportunity.
The insights from the analysis help the company:
Set the IPO price
Determine the number of shares to be offered
Evaluate the effects of going public on the company’s financial structure.
Forecasting Model
This type is also used in financial planning and analysis (FP&A) to build a forecast that compares to the budget model. Sometimes the budget and forecast models are one combined workbook and sometimes they are totally separate.
Merger Model (M&A)
The M&A model is a more advanced model used to evaluate the pro forma accretion/dilution of a merger or acquisition. It’s common to use a single tab model for each company, where the consolidation of Company A + Company B = Merged Co. The level of complexity can vary widely. This model is most commonly used in investment banking and/or corporate development
What Is Financial Modelling Used For?
Financial modelling is used for a wide range of purposes, including
Creating budgets and financial plans for companies
Forecasting future financial performance
Evaluating investment opportunities, such as mergers and acquisitions
Estimating the value of companies, assets, or projects
Creating what-if scenarios to understand how changes (such as fluctuations in market demand, or variations in production costs) can affect financial outcomes
Identifying potential business risks and quantifying their impact
Evaluating strategic decisions, such as entering new markets
Creating financial reports and presentations for stakeholders
Conclusion
Financial modeling is a set of numerical techniques used to forecast a company’s future growth. Based on the information in a company’s income statement, balance sheet, and estimates of future economic conditions, analysts can create cultured predictions of an investment’s future performance.