What is Financial Model
It is the summary of a company's performance, based on certain variables, that allows the business to forecast future financial performance and thus make better business decisions. That is, it allows a company to see the financial consequences of a decision in quantitative terms before making the decision. In order to construct the model, measurements and skills were obtained from the company's operations, accounting, corporate finance, and use of Excel spreadsheets, among other things.
They are an amalgamation of those skills and are assembled based on performance. They are then used to predict how a company will react to various economic situations or events.. These are frequently used to predict the outcome of a specific financial decision before a company commits any funds or resources to it. For more information, please see our guide to financial modelling.
Below, we've listed the most commonly used financial models among those who work in the financial modelling industry.
Three Statement Model
The three-statement model is the most basic setup for financial modelling. As the name implies, the three financial statements (income statement, balance sheet, and cash flow statement) in this model are all dynamically linked together using Excel formulas. The goal is to set it up so that all of the accounts are linked together and that a set of assumptions can cause changes throughout the entire model. It is critical to understand how to link the three financial statements together, which necessitates a strong foundation of accounting, finance, and Excel knowledge.
Discounted Cash Flow (DCF) Model
These types of financial models fall into the category of Valuation models. They are used in equity research and other parts of the capital markets, but not always.
People use DCF models to figure out the worth of a business. An unlevered free cash flow model is called a DCF model. It's a forecast of a company's free cash flow discounted back to today's value, called the Net Present Value (NPV).
The three-statement financial model is the basic building block of a DCF model. It connects the financials together and is the building block of the DCF model itself. When you look at the three-statement financial model, you see the cash flows. The DCF model takes those cash flows, adjusts them, and then uses the XNPV function in Excel to discount them back to today at the company's Weighted Average Cost of Capital (WACC).
Merger Model (M&A)
This type of financial modelling is a step up in sophistication from the basic model and is used to determine the pro forma accretion/dilution of a merger or acquisition. When consolidating multiple companies, it is common to use a single tab model for each company, with the consolidation represented as Company A + Company B = Merged Company. The level of complexity can vary greatly, and it is most frequently employed in investment banking and/or corporate development.
Initial Public Offering (IPO)
Investment bankers and corporate development professionals also use Excel to create initial public offering (IPO) models in order to determine the value of their company prior to going public. When developing these models, it is necessary to consider comparable company analysis in conjunction with an assumption about how much investors would be willing to pay for the company under consideration. An "IPO discount" is included in the valuation of an initial public offering (IPO) model to ensure that the stock trades well in the secondary market.
Leveraged Buyout (LBO)
A leveraged buyout (LBO) is a business acquisition in which a company is acquired primarily through the use of debt as the primary source of consideration. Private equity (PE) transactions are typically characterized by a private equity (PE) firm borrowing as much as possible from a variety of lenders (up to 70 or 80 percent of the purchase price) and funding the remaining balance with their own equity.
In order to complete an LBO transaction, financial modelling with debt schedules is typically required. LBO financial models are an advanced form of financial modelling. When it comes to financial models, a leveraged buyout (LBO) is often one of the most detailed and challenging because of the many layers of financing that create circular references and require cash flow waterfalls. Outside of the private equity and investment banking industries, these types of models are not very common.
When it comes to a leveraged buyout transaction, the financial modelling that is required can become complicated. The following distinctive characteristics of an LBO contribute to the increased complexity:
A significant amount of leverage
Debt financing in multiple tranches
Bank covenants that are complicated
In addition to the issuance of preferred shares, management equity compensation and targeted operational improvements in the business are also planned.
The Budget model is used in financial planning and analysis (FP&A) to do financial modelling in order to put together a budget for the next few years, which is typically in the range of one, three, and five years in duration. It is intended for budget financial models to be based on monthly or quarterly figures, and they should place a strong emphasis on the income statement.
The forecasting model, which is similar to the budget model, is also used in financial planning and analysis to produce a forecast that is comparable to the budget model. Because it is similar to the forecasting model, it is also included in the Reporting model category of financial models, which is similar to the forecasting model.
Option Pricing Model
This financial model belongs to the Pricing model category of financial models, as indicated by its name. Option pricing financial models such as binomial tree and Black-Sholes are the most commonly used. They are based solely on mathematical financial modelling rather than specific standards, and as a result, they are built into Microsoft Excel as an upfront calculator.