Get an expert at affordable price

What is Financial Model

A financial model is a financial forecast for a particular period. Financial Model – Overview & Types

Use of Financial Model

The financial model is used for the following purposes:

• Funding of business/Startups
• Merger & Acquisition decisions
• Budgeting & Forecasting Process
• Business Valuation
• Management Accounting
• Selling and divesting assets
• Financial statement analysis

Key reasons to build a financial model

The key reason for building a financial model is as follows:

• Forecasting: Models are useful for ideas into an operational sustainable business. Financial forecast helps to a roadmap for your future.
• Fundraising: Financers like angel investors, Venture capitalists, or even banks, would like to evaluate the business plan to firm up their funding plan.
• Benchmarking: Financial models are helpful to compare the actual numbers with the financial plan and understand the variance with the plan.

Approaches for financial model

There are 2 main approaches to financial modeling:

Top-down forecasting:

This approach builds a model from a macro to micro perspective. Essentially, estimates total market then narrows it down to the revenue target for the company. Essentially, the approach uses the big picture and narrows down to company specifics target.

Bottom-up forecasting:

This approach uses forecasting of the company’s revenue, expenses, and investments. This approach starts from a low-level company’s data and working up to the company’s revenue target.

Types of Financial Model

The financial models can be of the following types:

Three Statement Model

The three-statement model is the basic form of the financial model. As the name suggests, there are 3 statements (1) Income & Expenditure Statement or Profit & Loss Account for the period (2) Balance Sheet as on a particular date (3) Cash Flow Statement.

Comparable Company Analysis (CCA or Comps)

A Comparable Company Analysis (CCA) is used to value a company using metrics of a similar size company. It assumes that a similar company will have similar valuation multiples assuming factors are the same.

A company’s valuation ratio determines whether the company is undervalued or overvalued.

Leveraged Buyout Model (LBO)

A leveraged buyout is a financial model to evaluate the acquisition of a company that is funded through significant debt components. This requires building complicated debt schedules. In this scenario, the investors put a small amount as equity and balance as debt or non-equity sources.

DCF based valuation

DCF model is used to value the company based on the Net Present Value (NPV) of the business future cash flows. DCF model uses forecasting future free cash flows to today’s value.

M&A Model

The M&A model tries to capture the accretion or dilution arising out of the merger and acquisition scenario.

Credit Rating Model

This model is mainly used by financial institutions to evaluate the company’s legitimate borrowing limits, probability of default, and applicable interest rates. A credit score is a weighted average of financial risk, management risk, business risk, and industry risk.

Sum of parts Model

The sum of parts model is built by taking several DCF models and adding them together. This model adds the value of all individual units of business deducted by liabilities to arrive Net Asset value of the company.

Consolidation Model

The Consolidation model includes multiple business units added into a single model.

Budget Model

The budget model is used by Financial Planning & Analysis (FP&A) professionals to build detailed forecasting for a defined period. It may use the historical trend to build future trends or even may use a Zero-based budget (ZBB) to build from granular details. Financial Model – Overview & Types