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What is a financial model?

A financial model is a tool used to help represent a company’s financial performance and forecast for the future. They are typically built in Excel and rely on the modeler inputting historical data to help cast predictions of how the company will perform in the coming years. Because of this, financial models play a significant role in helping firms to make important business and monetary decisions, such as whether they can afford to make an investment or not. Financial models are also used for analyzing large data sets or pricing financial instruments.

Who uses them?

Financial models are used by a variety of professions, including investment banking, accounting, and corporate finance. They are more complex than basic spreadsheets as they contain variables, such as inputs, outputs, calculations and scenarios, which are constantly evolving. For instance, if a variable assumption changes over time, so will the model and the calculations within it.

Types of financial models

There are different types of financial models, used to suit a variety of needs. These include:

3 statement model

This comprises a company’s income statement, balance sheet and cash flow statement to forecast into the future. This type of model tends to be the foundation on which more advanced models are built.

Leveraged buyout (LBO) model

This helps to identify a company’s debt capacity considering current market conditions. Private equity funds and their financial advisors will use these models to structure an LBO, assuming a certain investment horizon.

Discounted cash flow (DCF) model

This type of analysis discounts a company’s future free cash flow figures with an appropriate discount rate applied, to arrive at the intrinsic valuation of the company. Scenarios can easily be added to the model to assess the impact of changes in assumptions.

Merger & acquisition (M&A) model

An M&A model assesses the impact of a transaction on the acquirer’s financials. This will comprise an analysis of combined EPS and cash flow per share as well as the overall impact on the main financial statements, including credit rating impact. Models will also include a contribution analysis and allow for different financing scenarios and synergy assumptions.

Sum-of-the-parts model

This type of financial model is also known as the break-up analysis. It focuses on valuing separate divisions within a company, using a variety of valuation methodologies such as DCF and trading multiples.

Comparable company analysis model

This is a relative valuation method which uses the ratios of similar firms in the same industry to assess the value of a company.

What makes a financial model successful?

Firstly, a financial model must fulfill its objective. Will it help aid decision making? Does it have an obvious conclusion? Has the information been presented clearly and are users able to modify the model easily? These are all important questions to ask when stress-testing any model. Secondly, a successful financial model must be reliable and error-free.

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