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Pankaj Tyagi
| Updated: 07 Apr, 2020 | Category: Finance & Accounting

What is Financial Modeling and How It Helps Businesses to Grow?

Financial Modeling

A financial model is a replica of a financial scenario. The scenario can be, for example, figuring out the share price of a corporation based on the set of economic conditions; or what the performance value of an organization can be based on a collection of financial circumstances.

What is Financial Modeling?

Financial modeling is the process of building such situations; a good model is one that can replicate the real-world scenario. But financial modeling cannot consider as a career in itself! Instead, it is a technique, which serves different purposes. The financial model[1] helps companies to make business decisions as fast as possible.

For example, to figure out the share price of an organization:

  • Financial modeling to be done comprehensively. That is, by using various techniques and past performance records based on competition, growth, cost, etc. 
  • After that, the estimation of the share price is done via various techniques. Likewise, to get the exact estimation of the enterprise value, financial models will need to be outlined and tested. For all models, once the model is built, an analysis tells you what needs to be done.

Financial model help businesses make decisions about :

  • Boosting capital.
  • Acquisitions (businesses or assets)
  • Extending the current footprint of the company.
  • Trading or seizing business units and assets.
  • Forecasting and Budgeting.
  • Capital allocation
  • Valuing a business

Who builds financial models?

  • Investment banking is closely related to the merger, acquisition, and capital raising and therefore, analysts and associates spend a lot of time building a financial model.
  • Inequity research, analysts, and associates make a recommendation about what companies to invest in acquiring financial models.
  • In private equity, analysts and associates again build a model to decide which company the private equity firm wants to acquire and how much they should pay for them.
  • Credit analysts need models to sum out how much money they can lend to a business. 
  • Financial planning and analysis or FPEA analyst and managers build a model to forecast and plan an operating company.
  • Corporate development analysts and managers at an operating company use models for mergers and acquisitions. There are a lot of career paths that require financial Modeling skills.

Procedure for Building Financial Modeling

  • Financial modeling starts with collecting the historical data and putting it into an excel generally at least three years of information. 
  • From there, you can calculate ratios and metrics such as margin, growth rate, and turnover rate. 
  • Once you analyze the past, you can make those assumptions about the future, such as margin, growth rate, capital spending, etc. That drives a forecast, and the forecast is the three financial statements all linked together in Excel. 
  • Once that is done, valuation can layer on top. Discounted cash flow analysis, which calculates a net present value, is the most common type.
  • On top of that, there can be additional analysis such as sensitivity, charts, dashboards, and graphs.

What is the hallmark of a competent financial model?

Well, an excellent financial model has to be simple yet detailed enough to handle complicated situations and transactions. There are some general best practices when it comes to building financial models.

  • It should be well structured with an easy-to-follow layout.
  • It should be easy to understand.
  • Drivers and assumptions should be laid out clearly.
  • Simplicity triumphs complexity; it’s better to be approximately right than precisely wrong.
  • Accuracy is the key; all of the calculation has to be correct. Don’t confuse simplicity for inaccuracy.
  • It’s essential to focus on the key issues, what are the main drivers of a model. There are usually just 5 to 10 fundamental assumptions that make or break business or transaction, focusing on those.
  • Visual output is the key. Once you make the model, you won’t be able to share the inner workings of most people. Instead, you have to show them charts, graphs, and tables that illustrate the analysis.

Financial Modeling Examples

  • Three-statement financial model

The three-statement financial model combines and projects a company’s income statement, cash-flow statement, and balance sheet—into the future.

The three-statement model outlines the real financial standing of the company. This model acts as a standard and offers an in-depth overview of the company’s financial history and future performance. The three-statement model offers various scenarios that help users to understand how the company will respond to various circumstances.

  • M&A model

The merger and acquisition (M&A) model mainly designed to determine the influence of a merger or acquisition on the EPS of the newly formed company. The M&A model is quite useful in terms of forecasting the future impact of the company’s decision regarding a merger or acquisition. 

If the M&A model confers a rise in EPS, then the transaction is considered productive, which means it should result in growth. However, if it shows the adverse outcomes, the transaction is deemed to be dilutive, which means it will diminish the company’s value.

  • DCF model

The discounted cash flow (DCF) model is used to determine the valuation of the company. One of the critical characteristics of the DCF model is that it estimates current value while taking into account foresight for how much money something will earn in the future.

The DCF model can also be used to:

  1. Value shares of an organization
  2. Value a project within an organization
  3. Value a cost-saving initiative
  4. Analyze the cash flow
  • Sum-of-the-parts model

The sum-of-the-parts financial model allows large conglomerates to simplify their valuation. As the name advises, the sum-of-the-parts model values each division, business unit, or subsidiary independently and then combines them all. Sum-of-the-parts modeling used to determine the value of a company’s divisions.

  • CCA model

The comparable company analysis (CCA) model also serves the same purpose, i.e., valuation, but with a different approach. It’s far more fundamental as compared to the DCF model. The CCA model is based on the postulate that related organizations will have identical valuation multiples. It utilizes metrics from other companies with associated sizes and operations in the relevant industry.

  • LBO model

The leveraged buyout (LBO) model is utilized to probe an acquisition that finances the cost mostly with debt. The LBO model enables the buying organization to accurately estimate the transaction so it can obtain the best of the risk-adjusted internal rate of return (IRR).

Conclusion

If you want to stay abreast of monetary outage in the future, then financial modeling is a way to go. It helps you prepare against the different outcome and keep your business position intact even in the bad times. Hopefully, this guide enables you to understand what financial modeling is all about. If you seek more info, kindly head over to our official website – https://corpbiz.io.

Read our article:Filing of Financial Statement with Registrar

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Pankaj Tyagi

Pankaj has a diverse experience of writing research papers, blog, and articles during his college time. Earlier, he was working as a tax consultant in a financial firm, but his interest in writing drives him to pursue a career in the writing field.

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