This article will discuss the types of financial models, the step-by-step process of building a model, and some essential components that make up a detailed financial model.
1. Types of Financial Models
There are several forms of financial models, each developed for a particular use. Here are the most frequent ones:
1.1 Three-Statement Model: The most common basis of financial models is the Three-Statement Model, used as a base case for more detailed models. It includes;
• Income Statement
• Balance Sheet
• Cash Flow Statement
The three statements interlink and are used by analysts for analyzing how financial decisions affect the financial health of the company. This model is often used for simple finance analysis, such as budgeting and forecasting.
1.2 Discounted Cash Flow (DCF) Model: This model computes the value of a firm by projecting its expected future cash flows. First, it requires free cash flows forecasting and their subsequent discounting to their present value, using a discount rate, for instance, WACC. The model is highly applied in valuation analysis in the context of mergers and acquisitions, investment banking, and equity research.
1.3 Merger Model (M&A Model): This M&A model quantifies the financial impact of a merger or acquisition. It determines how an acquisition would affect the EPS of the acquirer with consideration of all synergies, financing structures, and balance sheets of the companies being consolidated. This model helps answer whether a deal would be accretive or dilutive to the EPS of the acquirer.
1.4 Leveraged Buyout (LBO) Model: It is called the LBO model. This is applied to weigh the purchase of a company based on a considerable amount of debt. The model used by private equity firms and other investors for the calculation of the leveraged buyout, focusing on anticipating return values with cash flow projections, debt repayment, and an exit strategy for returns on investment in terms of IRR.
1.5 Budget Model: Corporation budget models are used in day-to-day running to ensure the allocation of resources and financial targets. It is done through the presentation of revenues, expenses, and cash flows for a period, probably fiscal year. Budget models help and evaluate performance within an organization.
1.6 Consolidation Model: The consolidation model helps in consolidating various business units or subsidiaries into one consolidated financial statement. This model is particularly indispensable to companies that have many entities or segments because it allows them to get the overall health of their collective financials.
1.7 Option Pricing Model: In addition, valuation models for options, such as the Black-Scholes model, are employed to price financial derivatives, such as options. They help investors measure the theoretical value of the options using parameters like volatility, time left to expiration, and strike price.
1.8 Sensitivity & Scenario Analysis Models: Other Models-Sensitivity and scenario analysis models are helpful tools in gauging what will happen to financial outcomes if key assumptions change. Sensitivity analysis changes one variable at a time, while scenario analysis addresses multiple changes simultaneously. This is an apt kind of model that is especially useful for risk management.
2. The Financial Modeling Process
A financial model is a result of a step-by-step procedure to make it both accurate and useful. Here is the step-by-step process in financial modeling.
2.1 Define the Objective: First, the objective of the model must be defined. The objective will define the kind of model to build, the type of data required, and the level of detail. For example, a merger analysis model will differ from that needed for budgeting.
2.2 Obtain Data: Gathers appropriate financial and non-financial data. This includes past financial statements, market data, economic indicators, and industry benchmarks. The accuracy of the data is very important since a wrong entry in input data can give incorrect results.
2.3 Building Structure: It organizes the model by having separate sections for each component, like an income statement, balance sheet, and cash flow statement. Use easy-to-follow clear and logical layout of the model. Most best practices related to financial models have it arranged to keep the inputs, calculations, and outputs distinct with the aim of reducing errors and ease readability.
2.4 Input Historical Data: In putting historical data into the last few years, these will be the basis for projecting future performance. Historical data help identify trends and seasonality, thus making better projection possibilities.
2.5 Develop Assumptions are a necessity in the process of forecasting. These may range from growth rates, profit margins, and capital expenditure projections. Assumptions should be reasonable and as far as possible, based on reliable sources or industry standards.
2.6 Construct Forecasts: Use the historical data and assumptions to project future financial statements. For each statement, compute line items based on historical trends and assumptions. Probably the most commonly used forecasting technique is a simple percent change applied to historical data.
2.7 Link Financial Statements: Link the three financial statements together.
For example:
•Net income from income statement is transferred into the equity section in the balance sheet as well as for the cash flow calculation.
•Changes in the working capital affect the balance sheet as well as the cash flow statement.
2.8 Do Analysis: Once the model is complete, evaluate the output. Depending on the type of model, this will include calculating valuation metrics, return on investment, break-even points, or even debt repayment schedules. Sensitivity and scenario analysis can be helpful in understanding how changes in assumptions affect outcomes.
2.9 Validate and Test the Model: Check that the model works, that formulae have been entered correctly, that calculation results are accurate, and that assumptions have been validated. It is also useful to perform a “stress test” by applying extreme values, where appropriate, to check that the model responds as it should.
2.10 Review and Refine: Financial models are usually reviewed by other analysts or managers. Bring aboard any suggestions and improve the model as appropriate. It might be necessary to update frequently to reflect news data or assumptions that have arisen.
3. Elements of a Financial Model
A good financial model includes all or virtually all of the following elements, which together will give you some worthwhile, stand-alone insights.
3.1 Income Statement: The income statement, or profit and loss statement, shows the revenues, expenses, and profits of a firm during a period. Main elements are Revenue/Sales, Cost of Goods Sold (COGS), Gross Profit, Operating Expenses, Net Income.
3.2 Balance Sheet: A company’s balance sheet shows a snapshot of its total assets, liabilities, and equity at a point in time.
Components include: Assets-for example, cash, inventory, accounts receivable
Liabilities-for example, debt, accounts payable
Equity-for example, retained earnings, common stock.
3.3 Cash Flow Statement: Cash flow statement of inflow and outgo of cash into three major areas:
Operating Activities: Cash generated or utilized in the core business operation.
Investing Activities: Cash generated or used for investments.
Financing Activities: This is cash generated from financing activities which comprise issuance of debt and payment of dividend.
3.4 Assumptions and Drivers: Assumptions are the lifeblood of any financial model and will determine how good the forecast will be. Some of the most common considerations for assumptions include Revenue, Growth Rate, Expense Ratios, Interest Rates & Tax Rates
3.5 Ratios and Metrics: Ratios and metrics to be used in financial health and performance: Profitability Ratios: Gross margin, operating margin, net margin
Liquidity Ratios: Current ratio quick ratio
Efficiency Ratios: Inventory turnover, asset turnover
Valuation Ratios: Price-to-earnings (P/E), EV/EBITDA
3.6 Sensitivity Analysis: Sensitivity analysis checks the effects of the modifications of the key assumptions on the output. Often, such an analysis is conducted using the “Data Table” in Excel, by which one creates a number of different scenarios with different assumptions. That way, the user may calculate risks and identify important variables.
3.7 Visualization and Outputs: This will fasten the understanding of the take-away message of the model with graphs, charts, and summary tables with the stakeholders. It easily gives way to access by the non-financial professional and is handy for inclusion in reports and presentations.
Conclusion
It would be the most basic requirement in terms of skills because financial modeling greatly aids finance professionals in making strategic decisions, developing valuations, and assessing risks. Knowing that there are kinds of financial models, the process and what their component is will really help toward efficient and reliable models that deliver valuable insight. Proper practice with attention to details should enable financial modeling to emerge when it is needed for forecasting and planning and doing the investment analysis.