Creating a financial model involves designing a mathematical framework that explains the firm’s financial status and performance. It generates thoughts or estimates that help us understand how future events or decisions will affect our financial performance. Financial modelling most often uses spreadsheets and other applications that analyze and/or manipulate financial data with corporate analysts, corporate strategists and investors to produce scenarios and inform decision making.
The objective of financial modelling is not simply to produce predictions, but to support strategic decision-making related to investment appraisal, as well as mergers and acquisitions (M&A), which may involve resources or funding.
Core Elements of a Financial Model
A solid financial model comprises several interconnected aspects that mirror the business it depicts.
- Historical Data: The model begins by considering historical performance, such as income statements, balance sheets and cash flows.
- Assumptions: These are the things that lead the forecast into what it will become, such as growth rates, cost structure or inflation.
- Financial Projections: The model uses the assumptions to predict the company’s future financial statements.
- Valuation and Metrics: Key metrics such as Net Present Value (NPV), Internal Return Rate (IRR) or Return on Investment (ROI) enable the performance to be assessed.
- Case and Sensitivity Analysis: These are sections of the Business Plan Model that allow testing assumption changes on financial results, to provide a ‘risk radar’.
Major Methods of Financial Modelling
Types of Financial Models Financial models can vary depending on what they are trying to explain. The most widely used techniques are described below.
1. Three-Statement Model
The three-statement model serves as the foundation for most financial analyses. It combines the income statement, balance sheet and cash flow statement in one dynamic model. The model enables estimated profits to be projected, liquidity to be evaluated, and operational changes to be identified in terms of their influence on financial sustainability. It’s very popular for corporate budgeting and valuation-type scenarios.
2. Discounted Cash Flow (DCF) Model
A DCF (discounted cash flow) model calculates how much a business is worth using its future expected streams of cash flows. These cash flows are then discounted to Present Value with the cost of capital. The model helps tell if a company or project is undervalued, fairly valued, or overvalued. It is especially prevalent in investment banks, equity research and corporate development.
3. CCA Model (Comparable Company Analysis)
This method, also called the trading comparables model, places a value on a company by comparing it to similar companies in the same industry. For relative valuation, EV/EBITDA, P/E or P/BV ratios are calculated. Such an approach responds to current market conditions and investor expectations, therefore allowing this method to also serve as a benchmark of dealing performance and for pricing stock issues.
4. Mergers and Acquisitions (M&A) Model
The M&A model both inspects the financial synergies of the two companies merging together. It looks at the purchase price, how the deal is to be financed, and any potential synergies to decide if the merger will create or destroy shareholder value. This model helps analysts test deal scenarios and confirm that the transaction is a win-win economically.
5. Leveraged Buyout (LBO) Model
Mainly employed in private equity, the LBO model allows an assessment of the viability of buying a business using leverage or debt. It calculates return for equity investors whilst considering debt levels, repayment schedules, exit strategy, and valuation. The model is complex, but critical for analyzing leveraged transactions and investment returns.
6. Sensitivity and Scenario Analysis Model
The sensitivity and scenario analysis model is used to test the validity of assumptions made in a financial model. It evaluates how changes in variables may affect probabilities and valuations positively or negatively, such as varying rates, sales growth, or raw material costs. Sensitivity analysis allows organizations to forecast risks and develop contingency strategies at times of economic or market volatility.
Process of Building a Financial Model
- Establish the Objective: Determine the objective, which can be valuation, investment analysis, or business planning.
- Collect Historical Data: Gather financial statements that are accurate and complete for past years.
- Build Assumptions: Create realistic assumptions based on research in the industry and/or economic indicators.
- Create Financial Statements: Develop the income, assets, and cash flow statements into projected future periods in a logical manner.
- Connect and Review Data: Make sure that all the statements are connected, and all formulas flow properly.
- Perform Analysis: Run scenario modeling, valuations, and perform ratio and comparative analysis.
- Assess for Validity: Validate that the customized template creates real-life model results i.e. that the model is consistent, makes sense and is free of error.
Following these steps will help ensure a trustworthy model reflects actual business behaviour.
Advantages of Creating a Financial Model
- Strategic Decision Making Support: The model provides a visual landscape of how decisions affect financial performance.
- Increased Valuation Capability: The model allows for realistic and reasonable valuations of the company and to assess investment.
- Ability to Mitigate Risk: The model shows potential risks or financial risks.
- Increased Planning and Control: The model supports budgeting, forecasting, and long-range budget, operational and strategic planning.
- Increased Trust: Providing models creates trust among investors and other stakeholders (e.g., the tearsheet model)
Conclusion
Corporate finance and investment analysis are fundamentally tied to financial modelling techniques, which convert raw financial data into actionable intelligence to make business decisions. When we value a company, create a plan for its growth, or create a merger, financial models quantify possible outcomes and advance rational decision-making.
As professionals develop expertise in financial modelling, their ability to analyze situations is improved for financial planning and balance. A well-organised model, using reliable information and solid assumptions, is perhaps a powerful tool for financial well-being and decision-making.
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