Financial modelling plays a crucial role in analysing the financial performance of businesses. It acts as a tool that uses mathematical models and forecasting techniques to make decisions about the company’s financial situation.
Businesses create financial models to analyse growth revenue, future costs, assets, liabilities, etc. Financial modelling uses assumptions to serve purposes like valuation, budgeting, risk management, investment analysis, and much more.
Types of financial models
There are various types of financial models created as per the needs of the businesses, which include,
1. Three-statement Financial Model
The 3 statement model in financial modelling integrates three core financial statements: the income statement, the balance sheet, and the cash flow statement. These statements forecast how well the business performs using various assumptions.
These statements collectively include the company’s revenue, expenses, debt, equity, cash, and cash flow over time. The 3-statement financial model acts as a base for various other advanced models such as the DCF model, M&A model, financial analysis etc. It is built by first entering and analysing historical results.
Such models act as powerful tools for the company as they allow the company to modify assumptions on one part of the model to check how accurately it influences the other areas of the model.
2. Discounted Cash Flow Model (DCF)
Discounted Cash Flow, commonly known as DCF, is a method used to analyse whether an investment is worthwhile based on a company’s projected future cash flows.
If you are looking to understand how much worth an investment in a business would be, the DCF model will come into the picture as it helps to understand whether the companies are currently undervalued or overvalued.
The investment is considered profitable if the DCF is higher than the present cost. This means the higher the DCF, the better the returns an investment can generate. If the DCF is lower than its present cost, such investment can be risky.
You can calculate a company’s valuation using the DCF calculator on Finnovationz.com.
3. Merger model (M&A)
Businesses often opt for mergers and acquisitions in the competitive market. This is why it becomes important for the company to analyse the financial implications of such a deal by calculating the combined value of the two companies.
The M&A model evaluates the financial feasibility and the result of such a merger or acquisition. The M&A model is considered one of the core financial models in Investment banking and corporate development.
It helps to analyse the factors such as potential cause saving from acquisition, cost of acquisition projected revenue growth, earning per share, the effect on cash flow, and the overall return on investment.
4. Comparable Company Analysis (CCA)
For instance, you are looking to buy a car and want to know its worth. You will look for similar models under your budget and compare the features and prices. This financial model works similarly.
The CCA model helps the company evaluate the value of a business by comparing it to other similar businesses in the same industry. It is a relative valuation method that is derived from comparisons with its competitors.
This method will compare things like revenue, profitability, valuation, market capitalisation, and expected return on investment.
5. Leveraged Buyout Model
One of the most advanced types of financial models is the Leveraged buyout model. It assesses the financial liability of acquiring a company using debt.
This model helps the acquirer to analyse the potential returns from such an investment and to determine whether that target company is worth the price or not. It helps the company to determine the maximum amount it can offer for the acquisition which is the floor valuation.
6. Forecasting model
As the name suggests, this model helps the company forecast its future financial performance with the help of its historical data management expectations and market trends. It also involves budgeting which allows the company to allocate resources, track its financial performance and control its spending.
The budgeting and forecasting model combines the two processes to help the company develop a viable financial plan, set its targets, and monitor the progress for the whole year.
7. Option Pricing Model
It is a mathematical model that calculates the value of an option. There are two types of option pricing models: Binomial tree and Black-Scholes.
To compute the fair valuation of an option, the factors that can be considered are current price, strike price, risk-free interest rate, volatility, and time to expiration. Traders and investors use this model to find the potential profitability of various options and make profitable investment decisions.
8. Precedent Transaction Analysis
Comparison helps us to choose the better option. This is similar to the case with the Precedent transaction analysis model. This model helps to value a company based on the offer price paid in the recent merger and acquisition transaction for comparable companies.
If you analyse past deals,+ can get a sense of a company’s fair valuation. However, there are two significant drawbacks to this model: Date consideration, as only recent transactions can be included – and accessibility to limited data, as the acquirer is not obligated to disclose the purchase price.
Conclusion
To conclude, various types of financial models are effective in financial decision-making for both individuals and businesses. To choose the right model, you first need to understand your needs and improve your financial modelling skills.
You can consider a few factors while you select the financial model, which can be your goals and purposes, the nature of business and industry dynamics, available data and information and the complexity of the model with the time and resources required.
As we all know, financial models are one of the most powerful tools when it comes to financial performance analysis, and they become even more powerful if used correctly.
If you are someone who is looking to improve your financial modelling skills and understand the financial model better head to our Financial Modelling and Valuation course to understand it right from the base.