A financial model is a specific type of financial planning. In essence, businesses use financial modeling as a tool to reflect financial planning through calculation, measurement and quantification.
A financial model is a synthesis of a company’s performance along with specific inputs and assumptions, which helps a business predict future financial performance.
In other words, with a quantitative approach, a financial model helps the company calculate the financial results of a given decision or policy or project.
Skills and knowledges that are used to build financial models include: knowledge of business operations, accounting, corporate finance, and financial functions in MS Excel or Google Sheets or a programming language (if you plan to develop a software that help building financial models). Modeling is a combination of the above skills to analyze business performance and thereby analyze how a business responds to different economic situations or events. For example: What is the impact of an increase in lending interest rate or a decrease in the exchange rate on business operations? Should the project be implemented according to the ratio (contribution / loan) of 30/70 or 40/60?
Four popular types of financial models
A financial model will give mathematical representations (e.g. through formulas in MS Excel / Google Sheet or in a dedicated software) based on the model’s input variables. Input variables are inputs or assumptions about: revenues, expenses, cash flows, investment plans, borrowing and debt repayment plans, depreciation schedules, inventory levels, inflation rates, interest rates loans, exchange rates, etc.
These input variables are used in the model to calculate the outputs and to evaluate its own impact on these results. This allows the company to perform quantification or modeling of its decisions in upcoming policies and decisions; forecast the obligations and financial interests it will perform; and assess the requirements set forth by the business’s investors or lenders.
A simple example of a financial model is a cash budget table where the model will show the initial balance of the cash account, then reflect the cash inflow/outflow movements during the period and the resulting output is: the account’s closing balance.
Financial models come in different and varied forms depending on the intended use and characteristics of the elements used in the model. This article, for the purpose of introduction and within the scope of an overview, will introduce the four most basic and popular types of financial models as follows:
The Three-Statement Model
A 3-statement model (also known as “a integrated financial statement model”) is to forecast or project the financial position of a company as a whole based on building 3 financial statements:
Therefore, if there is a change in one financial statement, the other financial statements should adjust accordingly. From a financial modeling perspective, these financial statements should be interlinked using either Excel / Google Sheet or a dedicated software. The end result is that users are aware of the fluctuations of the components in particular and the fluctuations of the business in general.
The DCF (Discounted Cash Flow) Model
The DCF model, which is usually developed based on the 3-statement model, is a valuation method used to estimate the value of an investment based on its expected future cash flows. In other words, the model is based on the principle that the value of a business is equal to the present value of its future cash flows. Analysis of DCF model attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future.
The cash flow in this model will reflect the time nature when using the discounted cash flow (DCF) tool to calculate the NPV (Net Present Value) of the business and the IRR (Internal Rate of Return) of an investment with non-recurring cash flows or periodic cash flows, thereby determining the efficiency of investment decisions. To do that, the DCF model will evaluate the cash flows from the 3-report model, through making adjustments or discounting these future cash flows. Specifically, we use the XNPV function in MS Excel or XNPV function in Google Sheet to discount the cash flow to the present with the discount rate as the WACC (Weighted Average Cost of Capital) of the business.
The CCA (Comparable Company Analysis) model
A comparable company analysis (CCA) is a model that is used to evaluate the value of a company using the metrics of other companies of similar size in the same industry. Comparable company analysis operates under the assumption that similar companies will have similar valuation multiples, such as the rate of the EV (enterprise value) to the EBITDA (earnings before interest, taxes, depreciations, and amortizations). Analysts compile a list of available statistics for the companies being reviewed and calculate the valuation multiples in order to compare them.
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The M&A (Merger and Aquisition) Model
A Merger & Aquisition Model (a.k.a Merger Model) is an analysis representing the combination of two companies that come together through an M&A transaction. A merger model is usually built by consolidating finance reports of the two companies to give analysts ability to see the impact after merging. This model is usually used before a merging and acquisition deal.
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The main objective of a financial model
A financial model is to evaluate and show the performance of a business. Its main goal is to recreate almost exactly the actual operation of a business. Once the input factors/assumptions that reflect the firm’s performance, which are also the input variables of the financial model, are identified, financial analysts can model the financial effects of these variables in the model. From there, business decisions are measured and quantified. This is done through the testing of factors/assumptions to analyze their impact on the future financial results of the business. Some of the assumptions tested by financial modeling include: growth rates, profit margins, product lines, individual production segments/areas, and refinancing.
Since there are many types of financial models, it is important to define the purpose or “goal” of creating that model in order to make the right choice. In other words, in order to truly create a model that is useful in evaluating future quantitative decisions, companies need to determine from the outset what reasons and what factors they want to measure in relation to the future company performance. Once these factors are identified, a company can design and build the appropriate functionality of that model to compute the required results.