What is Financial Modeling?
The term “financial model” refers to the simulated real-world financial situation of a company. Financial modeling is the methodical approach used to build a financial model in which the historical finances of a company are captured in a spreadsheet and it is then used to build financial projection based on some market assumptions. Typically, a financial model is used to assess the business impact of any expected or unexpected future event based on which various business decisions are made. In other words, it helps in understanding how a company would behave in different business scenarios.
A step-by-step breakdown of Financial Modeling
There are several steps involved in a financial modeling process. The following step-by-step breakdown can help in building a perfect financial model.
- Capture the historical results of the subject and gather all market assumptions
- Start incorporating the assumptions into the income statement
- Start incorporating the assumptions into the balance sheet
- Build the associated schedules of the income statement and balance sheet
- Complete the income statement and balance sheet
- Build the cash flow statement based on the income statement and balance sheet
- Build discounted cash flow (DCF) analysis in the model
- Add different scenarios and perform sensitivity analysis on the model
- Build graphs and charts for the critical financial parameters
- Stress test the model and perform its final audit
Who uses Financial Modeling?
Some of the primary users of financial models come from the following background:
- Equity research / Investment banking: Financial model is an integral part of fundamental analysis. Equity research analysts and investment bankers use these models for determining the valuation of companies during fundraising or M&A transactions.
- Credit rating / Project finance: Financial model help analysts in projecting the future financial situation of companies which then aids informed decision making. Based on the model, the credit analysts assign ratings, while the project finance team assesses project viability.
- Corporate finance: Financial models are used by companies for assessing their own financial position, especially for deciding on funding plans for upcoming projects.
- Entrepreneurs: The entrepreneurs use financial models for presenting their business plans to potential investors, such as private equity. They usually run multiple simulations to capture different potential risks.
Types of Financial Modeling
Although there are many different types of financial models, some of the most commonly used financial models are as follows:
- Three-statement model: In this type of financial modeling, the three financial statements – income statement, balance sheet, and cash flow statement, are dynamically connected to build the ultimate model. These financial models are either classified as Integrated financial statement models or Reporting models.
- DCF (discounted cash flow) model: These types of financial models are used for valuing businesses and hence are categorized as Valuation models. The three-statement financial model (discussed above) is the basic building block of a DCF model. These models are primarily used in equity research and other capital market research.
- M&A (merger & acquisition) model: These types of models also fall under the Valuation category of financial models and are most commonly used in investment banking. These models are used for assessing the pro forma accretion/ dilution of a merger or acquisition.
- IPO (initial public offering) model: It is also a type of Valuation model. Investment bankers build these types of financial models to value their businesses before going public. These models indicate how much the investors would be willing to pay for the subject company.
- LBO (leveraged buyout) model: In a leveraged buyout, a company is acquired using high leverage or debt as the main source. These models are super detailed, complicated, and have multiple layers and hence are considered an advanced form of financial models. These types of models are usually used in private equity or investment banking.
- Sum of the parts model: These types of financial models also belong to the Valuation category. Such models are developed by taking into consideration many different DCF models by adding them together and hence the name.
- Consolidation model: It belongs to Reporting Model category and it involves the addition of several business units into one single model for further analysis. Usually, there is a tab for each business unit, which are then added into another tab to build the consolidated financial statements.
- Budget model: These types of financial models are used in financial planning and analysis for building the budget for future years, usually in the range of one to five years. These models are usually built based on monthly or quarterly figures.
- Forecasting model: These models are also used in financial planning and analysis for building forecasts that can be compared to the budget model. It also a type of Reporting model.
- Option pricing model: It falls in the Pricing model category. Black-Sholes and Binomial tree are the two main option pricing models. These models are based purely on mathematical modeling rather than any specific standards.
Categories of Financial Modeling
Specific categories of financial models cater to specific business problems. Some of the major categories (most of them have been mentioned in the previous section) of financial modeling are as follows:
- Project finance models: This category of models is used for evaluating a sizable infrastructure project for viability or feasibility. Detailed debt schedule forms a vital part of these finance models and they are usually long-term in nature.
- Pricing models: This category of models is built for determining the price that can be charged for a product. Typically, the price is the input and the profitability is the output of these models.
- Integrated financial statement models: This category of financial models involves three kinds of financial statements – income statement, balance sheet, and cash flow statement, and hence the name.
- Valuation models: This category of models is used for valuing businesses prior to joint ventures, contract bids, refinancing, acquisitions, etc., and hence requires specialized knowledge of various valuation techniques.
- Reporting models: This category of models is used for capturing historical financial statements and hence there is a school of thought that doesn’t consider them to be real financial models.
So, it can be seen that although financial modeling is a generic term for the industry, it can mean different things to different users based on their specific requirements.