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.

Key Learning Points

  • 3 statement models, incorporating a forecast income statement, balance sheet, and cash flow statement, form the foundation for most other financial models
  • Other financial models including LBO, DCF, M&A, sum of the parts, and comparable company models use different parts from the three statement model for their own outputs
  • LBO, DCF, comparable company and sum of the parts models all focus on valuing the company
  • An M&A model looks to bring two companies’ financials together and see if the combination will lead to an improvement in their finances, and thus where a merger should be sought

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 an 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 acquisition, assuming a certain investment horizon.

Discounted Cash Flow (DCF) Model

This type of analysis discounts a company’s future free cash flows with an appropriate discount rate applied, to arrive at a 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 brings together the financial models of two companies and assesses the impact of the 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 that uses the ratios of similar firms in the same industry to aid the valuation of the company you are focused on, in the same way, we might use the value per square foot of one house to help value another house.