Methods of Financial Modelling – A Brief
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 portfolio of the business, project owned by the company, or 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 project which has been proposed newly.
Financial analysts also use financial models for anticipating the impact made by a change in economic policy or such other event or decision of the company on the shares of stock of the company. And analysts also rely on financial modelling by using numerous forecasting theories and valuations for recreating business operations. Excel Spreadsheet is one of the major tools which is used for this.
So, in short, we can say that financial modelling is, the process which a firm undertakes to constructs a financial representation of some, or all, aspects of the firm or given security. The model would be usually holding characteristics by performing calculations and makes recommendations based on that information which is available. The model may also summarize the particular events. And this would be made for the end-user and would also provide them with the direction regarding 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 this includes:
– Income Statement
– Balance Sheet
– Cashflow Statement.
The majority of the companies utilize these three types of financial statements for representing their cost-revenue and also the balance sheet items. And when this type of financial model is developed, it should be appropriately classified under different sections for normalizing the company’s business so as to increase or decrease the revenue, cash flow, or margin earned by the company. This is basically used by banks and financial institutions for evaluating the historical and future performance of their corporate borrowers so as to ensure that they would be able to earn back the money lent, from such borrowers along with the applicable interest.
Credit Rating Model
In this, the three-statement model is utilized 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 it is operating in,
– 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 amortization ratio),
– P/B ratio (Price-to-Book Value)
It is used basically when analyst needs to compare a company with its peer companies in the industry so as to understand its standing within the same.
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 would then be summed up for calculating the actual worth.
This will be used by investors for evaluating the worth of a start-up before they invest their money in the same. Stock market investors also use the same for fundamental analysis to see if a company is trading higher or lower of the actual worth of their stock.
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 balance sheet for debt-heavy capital structure,
– to come up with an acceptable IRR (Internal Rate of Return) and,
– an exit value which is completely based on EV/EBITDA multiple.
This is basically used when an acquirer company is using debt to finance their cost of acquisition majorly 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 towards a more advanced model and 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 for grabbing 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 majorly 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 options at a given time.
The Binomial Model and Black Scholes Models are used majorly under this which are complex statistical methods. Basically, these are used by options traders prior to taking a position on large 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.