Before we venture into the details of the different types and techniques of financial modelling lets first understand what exactly financial models are and why do companies form such models. A financial model is essentially a mathematical representation of a company or an entity’s financial operations and statements. It is mainly used to forecast the future financial performance of a company by making appropriate assumptions as to how the particular company can perform in the coming financial years. Alongwith this it is also acts like a risk management tool for analyzing a host of financial economic situations. Financial modeling involves a lot of calculations to provide the final recommendation and projecting the cash flow statements, balance sheet and income statements. This is done with the help of building schedules such as debt schedule, amortization schedule, depreciation schedule and working capital management. The financial performance of a company is thus projected in various walks of business sectors like real estate, personal finances, banks, other financial institutions, non-profit organizations, oil and gas projects, etc. Furthermore, these financial models are utilized for many other purposes like arbitrating an IPO, deciding on a probable merger or acquisition, etc.
There are a vast of range of financial models that companies use based on what exactly a company is looking for. There are different financial models for different needs. Hence a company should first be clear as to what answers it actually wants. While most of the financial models provide weightage to valuation some of them also cater to calculate and forecast risk, analyze the ongoing and future economic trends or maybe understand the performance of a portfolio. Let’s look at some of the financial models that are used in companies and how they can be helpful.
Leveraged Buy Out Model
This kind of model is used when a company is looking to acquire and a significant sum of borrowed funds is used to meet the requisite acquisition cost. This kind of model is mostly used by bulge bracket investment firms and sponsors like Private Equity firms who not only want to acquire companies but also want to sell them later at a better profit. Thus in simple terms this model is used to determine whether or not the sponsor can afford to invest such a big amount and at the same time get enough return on the investment.
Discounted Cash Flow Model
The discounted cash flow model is one of the most widely used financial model across all sectors. It works on a very simple theory that the worth of a business is the sum of its projected future free cash flows, discounted at a suitable rate. It is thus a valuation method which uses free cash flow and discounts to help arrive at a value which will in turn help evaluate the potential of an investment. Investors use this method a lot to understand the absolute value of a company.
Option Pricing Model
According to definition Options are derivative contracts that give a particular holder the right but at the same time not the obligation to buy or sell an underlying instrument at a given price or before a particular future date. Option traders usually lean towards using different option price models to arrive at a current theoretical value. Option pricing model is a kind of financial model that uses certain fixed variables like underlying price, strike, etc and also forecasts for implied volatility. This is usually done to compute the theoretical value for a specified option at a certain point of time. Variables will likely move up or down over the existence of the option, while the option’s theoretical value will adjust to reflect these changes over time.
Sum of the Parts Model
This kind of financial modelling is also known as break-up analysis. In this kind of model the valuation of a company is carried out whereby the value of its divisions are determined (taking into account the fact that the company was being broken down and spun off or they were being acquired by another company).
Merger and Acquisition Model
Merger and acquisition model mainly consists of accretion and dilution analysis. The purpose of an acquisition model is essentially to present to the clients the impact of an acquisition to the acquirer’s earnings per share and how the changed or new earnings per share after the acquisition will be better or worse. When the earnings per share after the acquisition is higher it is called accretion while if the opposite happens it will be called dilutive.
Comparative Company Analysis Model
This kind of financial modelling is mainly used by most of the investment banks and can also be called “comparable” or “comps”. In this kind of analysis the major step that is taken is that the financial numbers and metrics of a company is compared against similar firms in the industry. A peer group analysis is undertaken for this. It is based on a simple assumption that similar companies would ideally have the same valuation multiples, for example EV/EBITDA. The process involved includes selecting the peer group of companies, gathering appropriate statistics of the company under view and then comparing them against the peer group.
Thus we can see that different kinds of financial modelling techniques are used for different situations. These models essentially help business professionals make the correct decisions with the help of the answers that they procure form such analyses. Applying the right kind of model and gathering the right kind of information for such analyses also forms an important past of the whole process as a single mistake can be detrimental to the health of the company. The analyst should know all the advantages and disadvantages which must be aligned to the company’s investment philosophy. Thus financial models give us a deeper understanding of the company and discovers anomalies that an investor would have normally missed. Hence it is an important tool that can be used time and again to give solutions as and when required.