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
- Forecasting models allow analysts to look at the 3 financial statements in detail or select a particular part such as Segment Revenue and undertake deep dive analysis
- 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
- IPO models assess the merits of listing a company including the costs associates and sources and uses of capital
- Divestiture models will strip out a sold business segment or unit from the financials so that future forecasts are derived from the post-divestiture financials
- Options pricing models will assist in the valuing options with the current market climate
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.
10 Types of Financial Models
There are different types of financial models, used to suit a variety of needs. These include:
1. Three Statement Model
The three statement model is comprised of the company’s three financial statements: the Income Statement, Balance Sheet and Cash Flow statement. Analysts will gather information on the historical and most recent performance of the company and then use this data to forecast future performance such as revenue and profitability. This type of model tends to be the foundation on which more advanced models are built.
2. Forecast Model
Forecast models can be used to analyze performance within a company or a particular business division. Financial forecasting involves taking a company’s historical reported financial data and using it to build future output estimates. It has a fundamental structure, which includes four main steps plus a logical process linking these pieces.
The four components are:
- Input historical data: such a Sales breakdown, Income Statement and Balance Sheet data
- Build ratios and statistics based on the historical data: this can look at all three financial statement or focus on a particular area such as cash flow generation
- Make future assumptions: which can be built into scenarios if needed
- Forecasting financial data: analysts will need to check that the assumptions being used in the forecasting are prudent to create a robust model
Creating a model in this way allows for building scenarios or performing a deep dive on a particular part of the business. Typically forecast models will look closely at revenue and profitability by segment or business division. It may include other metrics which are integral to the sector such as ‘Sales per square foot’ if looking at Retailers or ‘Customer acquisition cost’ for SaaS companies.
Download the free template showing how to forecast a basic Income Statement and Balance Sheet from the free resources section.
3. Leveraged Buyout (LBO) Model
The LBO model helps to identify a company’s debt capacity, taking into consideration current market conditions. Private equity funds and their financial advisors will use these models to structure an LBO acquisition, assuming a target investment horizon. LBO models can create scenarios to model various types of debt funding available when planning a leveraged buyout.
4. Discounted Cash Flow (DCF) Model
DCF analysis focuses on cash generation within a company to determine its valuation. The model 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 within the assumptions. DCF models are mostly suitable for mature companies with the ability to generate solid cash flows.
5. Merger & Acquisition (M&A) Model
An M&A model brings the financial models of two companies together and assesses the impact of the transaction on the acquirer’s financials. This will typically comprise of 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. M&A models will focus on synergy assumptions from the new combined entity and both from a revenue and profitability standpoint as well as a cost-saving one.
6. 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. This is a useful valuation technique when a company has multiple divisions which produce different types of goods or services: some may be best analyzed on a cash-flow generation basis, and others may be best valued on an EV/EBITDA multiple. SOTP models allow for this distinction and then when added together create a whole company valuation. This type of valuation technique is well suited to conglomerates and companies with diversified operations.
Our example below shows how analysts can create a valuation for Food and Beverage company PepsiCo by using sector-appropriate future EV/EBITDA multiples for each division.
7. Comparable Company Analysis Model
Comparable company analysis is a relative valuation method that uses the ratios of similar firms in the same industry to aid the valuation of the company in focus. In a broad sense it is similar to the way we might use the value per square foot of one house to help value another house.
Our example shows several beverage manufacturers and their current market caps (and enterprise values) along with the most recent sales figures, and forecast sales figures. From this perspective analysts can work out trading ranges for the sector such as EV/Sales and then apply them to the company being analyzed. When comparing companies, it may be justified to show one company trading on a premium multiple to another company.
8. Initial Public Offering (IPO) Model
An Initial Public Offering (IPO) model is a financial tool used to represent and forecast the financial performance of a company that is planning to go public by offering its shares to the public for the first time.
This model helps in determining the value of the company before and after the IPO based on the number of shares to be sold, the offer price, and how the proceeds from the IPO will be used. Before a company can be listed it must undertake significant preparation to ensure that the company meets the necessary listing requirements and can withstand scrutiny from external investors.
The example shown below looks at an IPO timeframe and quantifies what the new IPO shares could be listed at (looking at number of shares and price) and adds this to existing shares in the previously private company. To facilitate an IPO analysts will want to be aware of all the costs associated with the listing plus a plan to use the new capital on projects such as refinancing of loans. Any additional capital can then be used for internal projects such as expanding the company’s production lines for example.
9. Divestiture Model
Divestiture modeling involves taking the current group consolidated financials and converting them so that a divested business is no longer included. When analyzing a company with a divestiture, the current reported accounts would be split into two sets of financials – one excluding the subsidiary and the other representing the subsidiary entity.
The modelling would first analyze the purchase price and what the proceeds will be used for.
In our example this would be a cash purchase, and the proceeds used for a share buy-back. Once the sale has been approved analysts would split out the divested division based on information provided by the company and estimates where needed. All future growth projections will then be based on the new company financials, making sure the divested division has been completely removed from financial statements.
10. Option Pricing Model
An option pricing model is a mathematical framework used to calculate the theoretical value of an option. These models take into account various factors such as the current market price of the underlying asset, the strike price, the time to expiration, volatility, and interest rates.
The primary goal of option pricing models is to determine the fair value of an option, which helps traders and investors make informed decisions. One of the most well-known option pricing models is the Black-Scholes model, which provides a formula to calculate the price of European-style options. Another common model is the binomial option pricing model, which uses a tree-like structure to represent different possible paths the price of the underlying asset could take over the life of the option.
Additional Resources
Financial Model Formatting – Cell Styles