Types of Financial Models

A financial model is defined as a mathematical representation of a company’s financial situation. It is a tool that helps businesses, analysts, and investors make informed financial decisions, plan for the future, and evaluate the impact of different scenarios. Financial models use historical data, assumptions, and various financial metrics to project future performance, assess risks, and analyze the implications of different business strategies. Spreadsheet software such as Microsoft Excel is a common tool for constructing financial models. Financial models range in complexity from simple budgeting models to complex M&A (mergers and acquisitions) models or option pricing models. Financial models are dynamic and should be updated regularly to reflect changes in the business environment and ensure the projections’ relevancy. They are critical in organisations for strategic planning, investment analysis, and overall financial management.

Components of Financial Models

1. Historical Data: Most financial models begin by analysing historical financial data. Statements of earnings, financial statements, statements of cash flow, and other pertinent data can be included.

2. Assumptions: Financial model users make estimates about future economic circumstances, market movements, corporate performance, and other pertinent aspects. These assumptions serve as the foundation for the model’s projections.

3. Revenue Estimates: Financial models frequently forecast earnings in the future based on variables including sales growth, pricing tactics, and market share.

4. Expense Projections: Models forecast future expenses by taking into account elements such as operating expenses, expenditures on capital, and other financial responsibilities.

5. Analysis of Cash Flows: The quantity of cash generated or utilised by the business is represented by cash flow, which is an important feature of financial models. Models evaluate cash flows from operations, investments, and finance.

Top 10 Types of Financial Models

I. Three-Statement Model

The three-statement model is the simplest basic financial modeling configuration. The goal is to integrate all of the accounts such that a set of assumptions may cause changes in the whole framework. The Income Statement, Balance Sheet, and Cash Flow Statement are the three main financial statements of a corporation, and a three-statement model is a complete financial model that incorporates them all. The financial results and position of a company over a given period are shown in a dynamic and integrated manner by this model. It’s critical to understand how to connect the three financial accounts, which necessitates a solid foundation in accounting, finance, and Excel. Below is an easy explanation of every element in the Three-Statement Model:

1. Income Statement: Also referred to as the Profit and Loss (P&L) Statement, the Income Statement shows the revenues, costs, and earnings of a business for a given time frame, typically a fiscal quarter or year.

Items	2020	2021	2022
Revenue	$1,000	$1,100	$1,210
Cost of Goods Sold	$400	$440	$484
Gross Profit	$600	$660	$726
Operating Expenses	$200	$220	$242
Operating Income	$400	$440	$484
Interest Expense	$50	$50	$50
Net Income	$350	$390	$434

2. Balance Sheet: The balance sheet shows the assets, liabilities, and equity of a business at a particular point in time. It is based on the accounting formula,

Equity + Liabilities = Assets.

Item	2020	2021	2022
Cash	$100	$110	$121
Accounts Receivable	$200	$220	$242
Inventory	$300	$330	$363
Total Current Assets	$600	$660	$726
Property, Plant & Equip.	$400	$440	$484
Total Assets	$1,000	$1,100	$1,210
Accounts Payable	$150	$165	$182
Short-Term Debt	$100	$110	$121
Total Current Liabilities	$250	$275	$303
Long-Term Debt	$150	$150	$150
Total Liabilities	$400	$425	$453
Common Stock	$400	$400	$400
Retained Earnings	$200	$275	$357
Total Equity	$600	$675	$757
Total Liabilities & Equity	$1,000	$1,100	$1,210

3. Cash Flow Statement: It classifies the inflows and outflows of funds resulting from financing, investing, and operating operations. It balances the balance sheet’s starting and ending cash amounts.

Item	2020	2021	2022
Operating Activities	$337.50	$366.50	$398.50
Investing Activities	-$100	-$110	-$121
Financing Activities	-$75	-$75	-$75
Net Change in Cash	$162.50	$181.50	$202.50
Beginning Cash	$1,000	$1,162.50	$1,344.00
Ending Cash	$1,162.50	$1,344.00	$1,546.50

Model Interconnection: Because the three statements are related to one another, modifications to one will have an impact on the others. As an example,

• Retained profits on the Balance Sheet are impacted by the net income from the Income Statement.
• Both the Cash Flow Statement and the Balance Sheet are impacted by changes in working capital.
• Capital expenditures and other investing-related activities have an impact on the cash flow and balance sheets.

The foundation of financial analysis, decision-making, and value is this integrated model. Advanced financial models, including the Discounted Cash Flow (DCF) model, are built upon it.

II. Discounted Cash Flow (DCF) Model

The DCF model extends the three-statement model by calculating the Net Present Value (NPV) of a company’s future cash flow. The DCF model takes the cash flows from the three-statement model, makes additional adjustments as needed, and then uses Excel’s XNPV function to discount the cash flows back to today at the company’s Weighted Average Cost of Capital WACC. The following are the primary steps for creating a Discounted Cash Flow (DCF) model,

1. Forecast Free Cash Flows (FCF): Determine the anticipated free cash flows that the investment will produce in the future. The amount of cash created by the company that can be given to debt and equity investors is known as free cash flow.

2. Find the WACC, or Discount Rate: Determine the Weighted Average Cost of Capital (WACC), which is an investor’s average expected rate of return. The weighted average cost of capital (WACC) considers the cost of debt, the cost of equity, and the percentage of debt to equity in the capital structure.

• E is the market value of equity.
• V is the total market value of equity and debt.
• Re is the cost of equity.
• D is the market value of debt.
• Rd is the cost of debt.
• Tc is the corporate tax rate.

3. Discount Future Cash Flows: Use the WACC to discount each future free cash flow back to its present value.

4. Calculate Terminal Value: Calculate the investment’s worth after the specified prediction period. The exit multiple approach or the perpetuity growth model is frequently used for this.

5. Discount Terminal Value: Apply the same WACC as previously to reduce the terminal value to its current value.

6. Sensitivity Analysis: To find out how changes affect the value, perform sensitivity analysis using different key assumptions (growth rates, discount rates, etc.). Compare the market price to the DCF value. Analyse the discrepancy between the calculated DCF value and the investment’s current market price. If the DCF value is more than the market price, the investment may be undervalued, and vice versa. There are limitations and uncertainties while building a DCF model and doing a rigorous assessment of assumptions is necessary. It is also essential to use this model along with other appraisal approaches and methodologies. The accuracy of the DCF model is also influenced by the reliability of the underlying assumptions and the predictability of the expected cash flows.

7. Sum of Present Values: To determine the entire intrinsic value of the investment, add the present values of the anticipated cash flows and the terminal value.

III. Merger Model (M&A)

An advanced model for calculating the pro forma accretion or dilution of a merger or acquisition is the M&A model. Using a single tab model for each company is typical, with the consolidation of Company A and Company B resulting in the formation of Merged Co. Diverse degrees of complexity may be present. Most frequently, this model is implemented in the investment banking and corporate development sectors. Building a merger model involves several important processes or components, starting with M&A model inputs (assumptions regarding financial statements and valuation inputs needed to drive the rest of the study), which are followed by a variety of M&A model assumptions, model evaluation, and model outputs.

IV. Leveraged Buyout (LBO) Model

A leveraged buyout transaction is an advanced form of financial modeling that typically necessitates the modeling of complex debt schedules. Because the numerous financing layers generate circular references and necessitate cash flow cycles, an LBO is frequently among the most complicated and challenging financial models to construct. Aside from private equity and investment banking, these types of models are not very prevalent.

V. Initial Public Offering (IPO) Model

Professionals in corporate development and investment banking construct IPO models in Excel to determine the value of a company before its initial public offering. These models incorporate an evaluation of comparable company analyses along with an estimation of the valuation that investors are inclined to offer for the target company. In an IPO model, “an IPO discount” is incorporated into the valuation to assure that the stock will trade reasonably on the secondary market.

VI. Sum of the Parts Model

This type of model is constructed by combining different DCF models. Following that, any other components of the firm that would not be suited for a DCF analysis (for example, marketable securities that would be valued based on the market) are added to the business’s worth. So, for example, you would add together (hence “sum of the parts”) the values of business units A, B, and C, minus liabilities D, to get the company’s Net Asset Value.

VII. Consolidation Model

This model incorporates many business units into a single model. Each business unit often has its tab, with a consolidation tab that just adds up the other business units. This is comparable to a Sum of the Parts exercise in which Division A and Division B are combined to form a single, consolidated worksheet. The implementation of the Consolidation Model has been most pronounced in the business and financial sectors. The process of consolidating the balance sheets, assets, revenues, and profits is prevalent in the finance industry. Business consolidation is the process by which two or more companies are merged to form a single entity. Amidst the IT growth of the year 2000, numerous start-ups emerged, and Baby Boomers established their presence in the corporate sphere. As a result of the innovations and developments that these companies had established as a niche in the industry, the larger corporations acquired them through mergers and acquisitions and other consolidation strategies, rebranded them under their flagship, and expanded their market dominance. The Consolidation Model varies across sectors. Some common types are as follows:

1. Consolidation in Finance: To project a firm financial statement for the parent company, the financial positions of its subsidiaries and the parent company are consolidated. This can be subdivided further into the subsequent categories:

2. Full Consolidation: The parent company consolidates the financial statements of all its subsidiaries into a single main statement using this method of consolidation. In this case, the parent company owns fifty percent of all subsidiaries and exercises the majority of decision-making authority. This practice is implemented to consolidate the financial status, revenues, and cash flows of all subsidiaries into a unified entity known as the parent company. This approach facilitates the elimination of intercompany transactions and provides a financial balance sheet that exclusively reflects external transactions in a balanced manner.

3. Proportionate Consolidation: Organisations that possess a substantial stake in the company and exert considerable influence apply this method of consolidation; however, they do not possess the ownership stake or authority of a key shareholder. In proportion to its ownership stake in the subsidiary, the parent company consolidates the financial statements, profits, and accounting information with the subsidiary’s financial statement. By doing so, the parent company can enhance its financial standing in the market. The invested company’s financial statements continue to be publicly disclosed under its name. 

4. Equity Consolidation:  When an investor company possesses a shareholding ranging from 20 to 50 percent but lacks substantial influence over decision-making processes, it may opt to engage in equity consolidation. The investor incorporates the revenue generated by the investee into its financial position. Profits and losses incurred by the investee are only incorporated by the investor into its financial statement. In contrast to the proportionate consolidation, the financial statement in this instance is not consolidated or presented as a single entity.

VIII. Budget Model

This is used to model finance for specialists in Financial Planning and Analysis (FP&A) to put together the budget for the upcoming year(s). Budget models are often based on monthly or quarterly numbers and place a strong emphasis on the income statement. One might use different budget modeling strategies to develop an optimal plan that aligns with the financial operations of the organisation. The following are the most common forms of budget modeling,

1. Formula Model: A formula model allocates funds under specific criteria, such as the size or requirements of a given department. By utilising this budget model, a clear and direct correlation can be established between resource allocation and priority setting.

2. Flexible Model: Budget models that are flexible permit the inclusion of multiple levels of sales data with distinct expenditures. This can be an excellent method for aligning anticipated expenses with realised outcomes.

3. Incremental Budgeting: It enables moderate and straightforward adjustments that have a significant impact on expenditures. It is generally most effective to utilise when one possesses a consistent sequence of priorities and an anticipated inflow of funds.

4. Rolling Budget: A rolling-based budget is revised after each accounting period. This model is most effective for organisations that must frequently adjust their budgets to reduce risks and maintain a competitive edge.

IX. Forecasting Model

This form of projection is frequently used in Financial Planning and Analysis (FP&A) to compare to the budget framework. Often the financial projections and forecasting models are incorporated into one workbook, and other times they are completely distinct. Examples of Forecasting models are,

1. Financial Forecasting Models: These models are utilised in financial planning and budgeting to forecasting forthcoming financial outcomes, including cash flows, revenues, expenses, and profits.

2. Sales Forecasting Models: These models are employed in the domains of marketing scheduling and allocating resources to make predictions regarding forthcoming sales patterns by leveraging past sales information, market trends, and other pertinent variables.

3. Demand Forecasting Models: They make extensive use of historical data, market trends, and other pertinent variables to anticipate future demand in the domains of supply chain management and inventory planning.

X. Model of Option Pricing

Binomial tree and Black-Scholes are the two basic types of option pricing models. Because these models are based solely on mathematical formulas rather than subjective judgments, they are essentially a simple calculator built into Excel. Option pricing models are mathematical frameworks that compute the theoretical value of an option by utilising specific variables. The theoretical value of an option is a calculation based on all known inputs that approximate the option’s true value. Alternatively stated, option pricing models find the option’s fair value. Finance practitioners could modify their trading strategies and portfolios with the knowledge of an estimate of the option’s fair value. Hence, option pricing models serve as effective instruments for finance experts engaged in options trading.

Conclusion

In conclusion, financial modeling is essential for informed company decision-making in today’s changing world. Organisations can identify risks, optimise resource allocation, and obtain insights by analysing and projecting financial data using advanced methods. Financial modeling improves stakeholder communication and strategic planning and forecasting, helping stakeholders grasp financial implications and opportunities.