Top 10 Types of Financial Models Explained
Understanding the 10 Key Types of Financial Models
Financial models are a must-have financial tool for every business. They help to make strategic decisions and guide businesses towards their goals. There are many types of financial models. But why is this so? Well, every business has a different requirement for which different financial models are built. For instance, one business might require a merger and acquisition model because of the acquisition events soon to take place. Whereas another business might only need the basic three-statement financial model for forecasting. Building a financial model that can be used for financial planning and analysis of FP&A successfully can be a hectic task. Each finance professional must adeptly navigate Excel to craft models that project future financial performance, enhancing their ability to make data-driven decisions. In this article, we are going to guide you about when to consider which financial model for your business.
Here, we will take a look at some financial modeling examples that fulfill different purposes. This article will help you understand when you need a particular type of financial model in Excel. So, let’s get on to the details of these different types of models.
3 Statement Financial Model
Three-statement model is perhaps the most basic version among the types of financial models. You will find almost every business creating this model for forecasting purposes. What does it include? Well, it includes the basic financial statements, as the name suggests; the income statement, balance sheet, and cash flow statement.
The income Statement shows the revenues and expenses of the company. It includes revenue from sales or services. This model is made based on historical performance and current data. Balance sheets, on the other hand, show assets, liabilities and shareholder’s equity. Cash flow statements include cash inflows, i.e., revenue etc, and outflows, like corporate transactions etc, for a specific period of time.
In the 3-statement financial model, you create schedules and assumptions that will help you predict the results of future years. You will find that the mathematical model of 3 statements is linked to each other in Excel. This feature makes the impact of any change easier to reflect on all statements automatically. The financial statement model helps businesses in making informed decisions to achieve their business goals.
DCF Financial Model
Next type of model we have understudy is discounting factor (DCF) model also know as Discounted Cash Flow DCF Model which is used for business valuation. DCF model used to estimate the intrinsic value of a company. It is estimted based on the present value of its expected future cash flows. DCF model is widely used in equity research and for valuing investment opportunities.
It takes the output of the 3-statement model. Along with that, it involves the estimation of future free cash flows. The forecast includes revenue growth, operating margins, working capital requirements, and capital expenditures. To convert these future cash flows into a present value, a discount rate reflective of the risk associated with the investment is used. This rate is often the weighted average cost of capital (WACC), which factors in the cost of equity and debt, adjusting for the capital structure of the company. One of the critical and challenging aspects of a DCF model is determining this rate, as it significantly influences the valuation.
Using the Net present value (NPV) function, you discount the cash flow you’re generating to the current date. It will help you realize whether your investment will cover your initial outlay and give you a positive NPV. You will find that the use of this model is essential when you wish to figure out where you stand in terms of investing today.
Merger And Acquisition Model
If a business is planning on merging or acquiring another business, then this model comes into play. It helps address a variety of issues and can get quite complex when you start to build this model. Since one company buys out another company or two merge together in this situation, you will require a certified CFO to help you with this model. A CFO will study the businesses of potential mergers, drive financial models and guide about the merging or acquisition.
Valuation methods such as Discounted Cash Flow (DCF) and Comparative Company Analysis (CCA) are commonly used within the Merger models to determine the fair value of target companies. Financial metrics and ratios are scrutinized to evaluate the financial implications of the merger, including earnings per share (EPS) and the internal rate of return (IRR). The model also forecasts future revenues, cash flow projections, and overall financial outcomes, considering both internal factors like operational efficiencies and external factors like economic conditions and industry trends. The creation of a financial model in Excel for the M&A model is quite a difficult task. Assets, liabilities, cash flow, and every other thing of both businesses must be considered.
CCA Financial Model
Another interesting model among the types of financial models is the comparable company analysis (CCA) model. Essentially, this is the easier version of a DCF model, and it has relatively simpler calculations. As the name suggests, you will find that the model helps you compare your company’s performance to others running in the industry.
To make this model, financial data and market information are gathered for the selected companies. Corporate finance professionals gather this information that typically includes stock price information, market capitalization, and fundamental financial data like revenue, earnings, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), and net income.
Using this model is simple and will help you figure out what the normal financial practice is in an industry. Equity research included in this model provides guidance to companies going public and to investors who are willing to explore new offered shares. By using the same or similar metrics from companies that are similar to you, you figure out your business value. However, this measurement will not consider the time value of money.
Sum-Of-Parts Financial Model
Another interesting model on our list of types of financial models is Sum-of-parts financial model. The Sum-of-Parts model is the ideal option for a business that operates on a large scale. This doesn’t only mean having too many assets to account for. Instead, businesses that have subsidiaries, conglomerates, and whatnot should be using this to make financial modeling easier for themselves.
How does this work? Well, the process of creating a financial model in Excel for this type is easy. You are required to value your business depending on your business unit. So, you will not be forecasting or valuing your entire company. Instead, you will be focusing on each division and then accumulating it all at the end. This is highly beneficial for larger organizations. Excel models that focus on forecasting future financial performance are invaluable for businesses aiming to evaluate long-term financial strategies and investment potential.
By adopting a Sum-of-Parts approach, companies can also achieve greater transparency in financial reporting, making it easier for investors and stakeholders to understand the value contributions from different segments of the business. This granularity allows for more precise strategic decision-making, facilitating the identification of high-performing sectors that may warrant additional investment, as well as pinpointing underperforming areas that might need restructuring. The model thus supports not only valuation but also strategic alignment and resource allocation across the enterprise.
Initial Public Offering Model
The IPO Model is particularly relevant for businesses considering going public, providing a projection of future revenues and market conditions that influence stock prices. The initial public offering (IPO) model is for the use of investors. It is developed in investment banking. Investment bankers create it before they go public so that they can present where the organization will be in the future.
The financial model accounts for an IPO discount that considers changes in the stocks as well. This is highly technical, so you would want a professional to take a look at all the details you require. It also includes a bit of the CCA model to help investors understand how the organization is valued in the market.
Furthermore, the IPO model often incorporates elements from various financial models to offer a comprehensive view. It includes key factors such as sales growth forecasts, financial ratios, and cash flow analysis to predict the future financial health of the public company. Utilizing advanced models, investment banks and private equity firms leverage these insights to structure the financing that maximizes potential returns while managing risk. This approach also aids in determining the optimal investment period and strike price for investors, aligning with the capital markets’ current and future projections. These elements are critical in ensuring that the IPO leads to successful market share acquisition and meets the anticipated future growth and valuation benchmarks set during the IPO planning phase.
Consolidation Financial Model
We talked about the Some-of-Parts model earlier. The consolidation model links to that only. While the Some-of-Parts model focuses on each business unit, the consolidation model is the amalgamation of all of them. For instance, your financial models in excel for different business units will be shown together in one consolidated financial model. The consolidation financial model in excel gives you a clear overall picture of your business. So, if you have various divisions running, then you will need to do build this model as well.
By merging the financial details from each division, the consolidation model enhances strategic planning and performance monitoring across the entire organization. It simplifies financial reporting and analysis, providing top management with vital insights needed for informed decision-making and long-term planning. This unified view is especially crucial for multi-divisional companies looking to streamline operations and assess overall corporate efficiency.
Budget Financial Model
Now, we have the financial budgeting model. Essentially, professionals working in the financial planning area create this model. It is used by a variety of businesses to help understand how to create budgets with their financial model in excel.
Most of the work is done on the income statement in this model. Moreover, rather than giving you an annual view, it takes on more of a monthly or quarterly layout. This makes it easier to allocate and create a budget using your financial model in Excel.
This approach allows for more granular control and monitoring of financial activities, enabling businesses to react quickly to changes in their financial landscape. By adjusting budgets in real-time based on actual performance, companies can maintain financial efficiency and improve their operational decision-making. This dynamic budgeting process is crucial for staying competitive in fast-paced market environments.
Option Pricing Financial Model
Among the types of financial models, the option pricing financial model is an interesting financial model. The option pricing model is mainly related to derivatives. They revolve around two main pricing mechanisms, which include the Black-Scholes model and the binomial model. It tilts more towards the technical side, so you want to ensure that there’s an experienced professional creating this. However, there are built-in formulas for this also in excel, so it’s not impossible to create on your own.
This model is particularly valuable in the financial industry, where it supports critical decision-making processes. By leveraging these models, financial analysts can determine fair pricing of options, which is essential for developing risk management strategies and enhancing investment analysis. The precision and technical nature of the Black-Scholes and binomial models make them indispensable tools in modern financial markets, allowing for the evaluation of various investment scenarios and potential outcomes based on market volatility and other factors.
Forecasting Financial Model
Lastly, we have the forecasting financial model in our pick on types of financial models. This helps in the financial planning aspect and then further aids in the analysis of your financial model. It incorporates historical financial data and, based on data, predicts future cash flow situations. You will find this mostly together with the budget model. Since both of them help in financial planning, you’re most likely to make use of both of them.
You will use your forecasting model and verify whether it falls in line with your budgets. It helps you assess whether your assumptions for the model fit with what you wish to expect. Additionally, the integration of the forecasting model with real-time financial updates can enhance its accuracy, allowing for more dynamic adjustments and timely decision-making. This synergy ensures that your financial strategy remains aligned with both current conditions and future projections, optimizing financial management across the board.
Frequently Asked Questions
How does the budgeting model work?
The budgeting model sets revenue targets and aligns expenses, creating a financial plan that guides organizational spending and helps achieve financial goals.
How does the forecasting model work?
The forecasting model predicts future financial performance using historical data, helping businesses plan strategically and manage risks.
How does the leveraged buyout model work?
The leveraged buyout (LBO) model evaluates the feasibility of acquiring a company primarily through debt, focusing on the target’s ability to service debt and generate returns.
Conclusion
All types of financial models are crucial for businesses as they help to make right business decisions. They provide a solid understanding about financial health of the company. Creating an effective financial model requires a lot of skill. It doesn’t matter which type you want to build as they all require expertise.Elevate Your Business Decisions with Oak Business Consultant’ Financial Modeling Services. Our expert team delivers customized financial models to guide your strategic planning and investment decisions. Contact us to transform your financial insights today!