How Many Types of Financial Models Are There?

Financial modelling involves creating a mathematical representation of a company’s financial situation, which can be used to make data-driven decisions, assess investment opportunities, and plan for growth. Three tools are used when creating financial models:

• Historical data – unless a company is a start-up (in which case comparable company analysis would normally be used), historical data of the past 3-5 years is used when creating financial models for a company.

• Existing and up-to-date industry information – industry information is necessary for conducting comparable company analysis, which involves assessing similar companies’ financial data to make future estimates about the company in question.

• Assumptions and insights about how the company will alter in the coming years, such as increase/decrease in demand – qualitative factors can be used to make quantitative financial estimates and predictions.
  

Different financial models serve different purposes. Here we cover some of the most commonly used financial models.

Three Statement Model

The three-statement model is used alone and as a bedrock for most complex financial models, such as discounted cash flow and mergers. Combining a company’s income statement, balance sheet, and cash flow statement into a single framework, this model helps to analyse a company’s financial performance by understanding the relationship between the three statements and assessing how changes in one statement will impact the others. They are used for financial analysis in contexts including; investing, budgeting, and forecasting.

To make a three-statement model, gather information for the three financial statements and link the information from each page to the other, so the information in one statement will automatically flow to the others. For example, net income in the income statement would flow into the cash flow statement and be added to retained earnings in the balance sheet.

The next step is to use historical and other relevant data to develop assumptions for the company’s future financial performance and to put the estimates in the future income statement, balance sheet, and cash flow statement. Following this, a sensitivity test can be run on the data to understand the risks and benefits of a decision. For example, you may estimate what would happen to a financial situation if the price of a product was halved vs. doubled, or a higher vs. lower revenue growth rate.

Discounted Cash Flow Model (DCF)

The DCF is used to assess capital risks by predicting unlevered future cash flows and discounting them to the present using a discount rate that reflects capital risks. Unlevered cash flow is the cash available once expenses have been paid, otherwise described as the cash available for debt payments.

DCF values an investment based on how much cash it will produce in the future, as money is worth more today than money in the future. Money can be invested and yield more returns and be impacted by inflation. This brings about cost and risk implications, which this model takes into consideration to help select effective investment and growth strategies. This model is also used to value a company and for budgeting/forecasting.

IPO Model

Companies use IPO models to value their business before going public. They look at comparable company analysis (industry comparable), demand, company history, and growth forecasts, and make assumptions about how much their investors would pay for the company in question. This valuation also includes an ‘IPO discount’ to ensure the effective sale of the stock in the secondary market. IPOs are used to raise capital for the company, which is further used for purposes such as company expansion, paying debts, fundraising, and buying new equipment/machinery.

Comparable Company Analysis

Often used in conjunction with other financial models but also by itself, this model is used to compare a company to a similar business, with similar size and operations. These companies must usually have similar valuation multiples like EBITDA before being compared. Accessible facts and valuation multiples for companies are collected for this to be done. This model facilitates IPOs, mergers, and acquisitions by determining a company valuation and stock price. It is also used in DCF financial modelling and for restructuring purposes.

Further financial models such as the Merger and Acquisition Model and Leveraged Buyout Model also exist. These are more complex than the aforementioned models and are used for mergers or buyouts.

If you want to learn more about financial modelling, learn to do your own financial models, or have our team at Horízōn work on them for you, please feel free to get in touch. As a business, you can save thousands per year by reaping the advantages of this highly effective tool. You can also attend a workshop with us, or check out more of our blog articles to learn more about financial modelling.