Different Types of Financial Models One Needs to Know
Financial models forecast an organization’s financial performance over time. These models are designed using Excel, with historical data to forecast companies' performance in the future. They also play an essential role in assisting enterprises in making informed decisions, such as whether to invest in a project. Bankers, economists, accountants, consultants, portfolio managers, quantitative analysts, and financial planners use this to reap perks from forecasting a company’s financial performance in the future.
Developing Financial Models
Several professionals in various streams of financial services use financial modeling. Investment banking professionals who work in M&A, equity and debt underwriting, credit, and trading use this for financial forecasts because it is a crucial aspect of each banking transaction. Several investment managers like mutual fund and hedge fund managers, private equity investors, and venture capitalists take help from the financial models to make better and more insightful investment decisions.
A management consultant offers advice and expertise for companies to improve their business performance operations, profitability, management, structure, and strategy. A financial model gives a base case for the companies and consultants to vary assumptions and determine an optimal plan of action.
Equity analysts rate stocks on a purchase, sell, or hold basis determined through valuation methods. Through these methods, they can analyze the fair value of a stock, compare it with the stock’s market value, and provide better recommendations. When an enterprise discusses financial outcomes, issues a trading update, or gives management guidance, analysts adjust their models and offer an optimum investment recommendation.
Two Types of Financial Models
The types of financial models are related to the jobs directly linked with the situational context. These models are of two types — internal models and external models. Understanding these models will help the business’s financial needs and future planning.
· Internal Financial Models
Most financial models give valuable input to an organization’s executive team for internal purposes, such as budgetary planning, business and market expansion, or consolidation to fit organizational requirements. The types of internal financial models are:
Ø Three-Statement Financial Model
The most common kind of financial model is the three-statement financial model, which comprises three financial statements, which are:
- Income Statement (“IS”): The Income Statement describes an enterprise’s profitability over a certain period, typically quarterly and annually. The starting line item is revenue upon deducting different costs and expenses, with the ending line item being net income.
- Balance Sheet (“BS”): A Balance Sheet is a snapshot of an enterprise’s resources (assets) and funding sources (liabilities and shareholders equity) at a specific point, like the end of a quarter or fiscal year.
- Cash Flow Statement (“CFS”): In the indirect approach, CFS offers information on cash inflows and outflows of an organization over a certain period. It assesses an organization’s ability to generate cash, manage operating activities, and meet financial obligations.
Ø Discounted Cash Flow (DCF) Model
To value a private business in the Discounted Cash Flow analysis in valuation method, a PE/VC organization becomes serious about acquisition. The target will likely disclose their books but need to be well-audited to ensure accuracy. This model is used as the primary barometer for private valuations due to the uncertainty of private organizations’ financial statements. Private organization's accounting statements include personal and business expenses in the case of smaller family-owned businesses and possess unexplained gaps across the board.
Ø Sum of the Parts Valuation Model
A conglomerate that has diversified business interests might require a different valuation model. In this model, the valuation of every business happens separately and gets added up for the equity valuations. To review beta, PE/VC enterprises either take help from the industry averages and then unleveled or lever that number based on the type of beta used and adjust the number accordingly depending on the target’s credit history.
· External Financial Models
Financial analysts usually adopt the external types of financial models to make business decisions impacting other enterprises. For instance, these models explain the combination with another business enterprise for financial decisions.
Ø Leveraged Buyout (LBO) Model
In a leveraged buyout, a private equity or investment banking organization (often called the financial sponsor) acquires a company with most of the purchase price funded through various debt instruments such as loans and bonds. The financial sponsor secures the financing package before closing the transaction and then contributes the remaining amount.
The investment horizon for sponsors is 5–7 years, at a point the company plans to exit by either:
- Selling the company to another private equity organization or strategic acquirer.
- Making the enterprise public via an IPO
Financial sponsors generally target returns of approximately 20–25 percent when supposing an investment.
Ø Initial Public Offering (IPO) Model
The IPO model is considered the most crucial for investors and corporate institutions. This model needs analysts to review the potential value of the businesses with comparable companies against an underlying assumption about what the potential investors can pay for the business’s stock potential.
| Read more: Underwriter IPO
Ø Merger Model
The merger model consists of the accretion and dilution of a merger or acquisition. In this model, the investment banking and corporate development professionals enhance their model complexity based on the business nature. For example, an analyst will develop a merger model to determine whether merging two enterprises would yield financial performance that exceeds the outcomes generated by every enterprise independently.
Wrapping Up
If an individual wants to excel in their finance career, then knowledge of the financial models will boost their chances for future planning. These models highly rely on the assumptions that help raise capital, enter new market segments, improve market share, and value an enterprise or assets.
