Financial Modelling is nothing but the task of building an abstract representation, which depicts the real-world financial situation. This is a mathematical model constructed for forecasting the performance of a financial asset, or a portfolio of the business, a project owned by the company, or an investment made. They are used as decision-making tools, as this will help in estimating the costs and also to project the profit of a newly proposed project.
Financial analysts also use financial models to anticipate the impact of a change in economic policy or other company events or decisions on the company’s stock shares. And analysts also rely on financial modelling by using numerous forecasting theories and valuations to recreate business operations. An Excel Spreadsheet is one of the major tools that is used for this.
So, in short, we can say that financial modelling is the process that a firm undertakes to construct a monetary representation of some, or all, aspects of the firm or given security. The model would usually hold characteristics by performing calculations and making recommendations based on the available information. The model may also summarise the particular events. And this would be made for the end-user and would also provide them with guidance on possible actions or alternatives.
Objectives of Financial Modelling
The following can be termed as the major objectives of financial modelling:
- Valuing a business
- Raising capital
Growing the business
- Making acquisitions
- Selling or divesting assets and business units
- Capital allocation
- Budgeting and forecasting
Financial Models Commonly Used
This is also known as the three-way financial model. There are 3 basic statements that are used for understanding a company’s financial performance, and these include:
– Income Statement
– Balance Sheet
– Cashflow Statement.
The majority of the companies utilise these three types of financial statements to represent their cost-revenue and the balance sheet items. And when this type of financial model is developed, it should be appropriately classified under different sections to normalise the company’s business and adjust the revenue, cash flow, or margin earned by the company. Banks and financial institutions use this for evaluating the historical and future performance of their corporate borrowers to ensure that they will be able to earn back the money lent to such borrowers along with the applicable interest.
Credit Rating Model
In this, the three-statement model is utilised and extended so as to prepare further projections, along with adding the future demand growth of the particular industry, their strength and quality management, quality of the collaterals provided by the borrower, existing loans, and other details which might be required by the lending agency or institution. Using details, a credit score would be calculated, which is nothing but a weighted average of financial risk score, management risk score, business risk score, and industry risk score.
And as stipulated before, this would also be used by Banks when they are lending money in accordance with the application made by a company, so as to ensure the legitimate borrowing potential of the company and also the applicable interest rate.
Comparable Company Analysis or Ratio Analysis
Keeping the company’s business profile as a base, like the:
– Geography in which it is operating,
– Product & Service category,
– Target customers,
and the financial profiles, like:
– Size of the company,
– Top and bottom line,
An analyst would determine a set of comparable companies and apply a set of various financial ratios across these sets of companies. These financial ratios include:
– PE Multiple (Price-to-Earnings),
– EV/ EBITDA (enterprise value to earnings before interest, taxes, depreciation, and amortisation ratio),
– P/B ratio (Price-to-Book Value)
It is used basically when an analyst needs to compare a company with its peer companies in the industry to understand its standing within the industry.
Discounted Cash Flow (DCF) Model
DCF is a valuation analysis model and is based on the projected future cash flows for assessing a company’s worth or value. The future cash flows will be discounted here using an appropriate discount rate, and this will then be summed up to calculate the actual worth.
This will be used by investors to evaluate the worth of a start-up before they invest their money in it. Stock market investors also use the same for fundamental analysis to see if a company is trading higher or lower than its intrinsic value.
Leveraged Buyout Model or LBO Model
The LBO Model is a valuation analysis model and, in a manner, similar to the DCF model. But the major difference here is that the LBO model takes into account significant debt financing. The purpose of this model includes:
– adjustments of the balance sheet for a debt-heavy capital structure,
– to come up with an acceptable IRR (Internal Rate of Return) and,
– an exit value which is completely based on the EV/EBITDA multiple.
This is basically used when an acquirer company is using debt to finance their cost of acquisition, mainly for determining the fair valuation and exit-return of the company being acquired, which may be private or public.
Merger and Acquisition Model (M&A)
This comes under the valuation category, and this type of financial modelling is used in more advanced models. It is applied to assess the pro forma accretion or dilution of a merger or acquisition. A single tab model is used for each company, where the consolidation is represented as ‘Company A merging with Company B to form a Merged Co’, i.e., A Co. + B Co. = AB Co.
It is most commonly used when two companies decide to merge to grab a higher market share, diversification, synergy, or other reasons. Investment bankers also use these types of models for determining dilution or accretion.
Option Pricing Model
These are complicated and are mainly used by professional option traders. These models would take into consideration a few parameters whose values are known to them currently, and some examples for this include the underlying price, strike price, and days to expiry of an option, along with forecasts or assumptions on other parameters, including implied volatility, to compute the theoretical value for specific possibilities at a given time.
The Binomial Model and Black Scholes Models are used primarily under this, which are complex statistical methods. Basically, these are used by options traders prior to taking a position on extensive options and also keep on recalibrating the value of the underlying options so as to understand the value of other options.
Hence, we can now conclude that, depending on the purpose, requirement, and the end-use of the financial model, one can choose any. But this should not be uniformly applied but developed, analysed, and changed from time to time in accordance with the needs.
