A financial model is a mathematical representation of the financial operations and financial statements of a company. It is used to forecast future financial performance of the company by making relevant assumptions of how the company would fair in the coming financial years. It is also a risk management tool for analyzing various financial and economic scenarios and also provided valuations of assets. These models involve calculations, analyzing them and then provide recommendations based on the information gathered. A financial model generally includes projecting the financial statements such as the income statement, balance sheet and cash flow statement with the help of building schedules such as the depreciation schedule, amortization schedule, working capital management, debt schedule etc. It encompasses the company’s policies and restrictions imposed by lenders that would impact the financial position.
Investopedia definition of Financial modeling.
The process by which a firm constructs a financial representation of some, or all, aspects of the firm or given security. The model is usually characterized by performing calculations, and makes recommendations based on that information. The model may also summarize particular events for the end user and provide direction regarding possible actions or alternatives
Why Financial Models are prepared?
Financial models helps in conducting historical analysis of a company, projecting a company’s financial performance used in various fields such as Project Finance, Real estate, Personal finances, Non-profit organizations, Banks, Oil and Gas projects, Financial institutions, Government, Investment banking, Equity research etc.
These professional models are predominantly used by the financial analyst and are constructed for many purposes, such as valuation of a company/security, determining the benefits/demerits of a takeover or merger, judging an Initial Public Offer (IPO), forecasting future raw materials needs for a corporation etc.
Types of Financial Models
There are various kinds of financial models that are used according to the purpose and need of doing it. Different financial models solve different problems. While majority of the financial models concentrate on valuation, some are created to calculate and predict risk, performance of portfolio, or economic trends within an industry or a region. The following are the different types of financial models:
1) Discounted Cash Flow model
Among different types of Financial model, DCF Model is the most important. It is based upon the theory that the value of a business is the sum of its expected future free cash flows, discounted at an appropriate rate. In simple words this is a valuation method uses projected free cash flow and discounts them to arrive at a present value which helps in evaluating the potential of an investment. Investors particularly use this method in order to estimate the absolute value of a company. If may want to learn more about Financial Modeling here
2) Comparative Company Analysis model
Also referred to as the “Comparable” or “Comps”, it is the one of the major company valuation analyses that is used in the investment banking industry. In this method we undertake a peer group analysis under which we compare the financial metrics of a company against similar firms in industry. It is based on an assumption that similar companies would have similar valuations multiples, such as EV/EBITDA. The process would involve selecting the peer group of companies, compiling statistics on the company under review, calculation of valuation multiples and then comparing them with the peer group.
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3) Sum-of-the-parts model
It is also referred to as the break-up analysis. This modeling involves valuation of a company by determining the value of its divisions if they were broken down and spun off or they were acquired by another company.
4) Leveraged Buy Out (LBO) model
Included in the types of Financial model is the LBO Model. It involves acquiring another company using a significant amount of borrowed funds to meet the acquisition cost. This kind of model is being used majorly in leveraged finance at bulge-bracket investment banks and sponsors like the Private Equity firms who want to acquire companies with an objective of selling them in the future at a profit. Hence it helps in determining if the sponsor can afford to shell out the huge chunk of money and still get back an adequate return on its investment.
5) Merger & Acquisition (M&A) model
Merger & Acquisitions type of financial Model includes the accretion and dilution analysis. The entire objective of merger modeling is to show clients the impact of an acquisition to the acquirer’s EPS and how the new EPS compares with the status quo. In simple words we could say that in the scenario of the new EPS being higher, the transaction will be called “accretive” while the opposite would be called “dilutive.”
6) Option pricing model
As it is defined “Options are Derivative contracts that give the holder the right, but not the obligation, to buy or sell the underlying instrument at a specified price on or before a specified future date”. Option traders tend to utilize different option price models to set a current theoretical value. Option Price Models use certain fixed knowns in the present (factors such as underlying price, strike and days till expiration) and also forecasts (or assumptions) for factors like implied volatility, to compute the theoretical value for a specific option at a certain point in time. Variables will fluctuate over the life of the option, and the option position’s theoretical value will adapt to reflect these changes.
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