An Introduction to Understanding the Diversity of Common Financial Model Types
Financial modeling is often thought of when it comes to creating financial projections for your business plan. While this is a common application, financial modeling is actively used by businesses of all sizes across all industries to aid in everyday decision-making. Whether you need a valuation of your company for investment purposes, want to know the impact of adding a new product line, or need to justify a new hire, financial models will help.
First and foremost, it is important to make sure you are clear on the difference between models and projections. Beyond that, if you are new to financial models, it is important to understand their diversity – from the simple to the complex – and how they are applied every day in various business situations. That starts with a basic understanding of some of the most common types.
This is the model people tend to think of first when considering financial modeling. The three-statement model, as the name implies, results in an output of the three primary financial statements of a business: the profit & loss (or income) statement, balance sheet, and statement of cash flow. In this model, all statements are interlinked together. This allows information input into one statement to properly flow through to relevant places in the other statements.
This model answers questions about where a business’s financial position is headed. This can be used to set financial statement projections for a business plan, develop a budget for the next year (or several years), create short-term forecasts, or simply evaluate the impact of potential opportunities on your current financial position.
Discounted Cash Flow (DCF) Model
This is one of the financial models used when determining valuation. Essentially, a discounted cash flow model looks at the expected value of cash flow in the future and converts it – also known in this context as discounting it – to its value in present day.
This model not only applies to determining the value of an entire company. It can also be applied to valuing shares of a company, a potential project, or any initiative a company may wish to explore that will have an impact on cash flow.
Comparable Company Analysis (CCA) Model
While some of these financial models are far more complex than their descriptions may indicate, the CCA model is fairly straightforward. It assumes that within the same industry, similar companies will be valued comparably.
This is a relatively quick way to get a ballpark estimate of the current value of a company. However, because it is just an estimate, a more formal valuation method will usually be required.
Merger and Acquisition (M&A) Model
The M&A model’s purpose is given away by its name. This model focuses on determining the impact, specifically as it applies to earnings per share (EPS), of merging with or acquiring another business.
Typically, in a spreadsheet, each entity’s information will be set up on its own tab/sheet with a final tab revealing the end result. It indicates if the merger or acquisition will have a positive or negative impact on the EPS of the existing business.
Leveraged Buyout (LBO) Model
This is one of the most complicated and advanced forms of financial modeling. The purpose of this model is to assist those considering acquiring a company primarily with the use of debt equity. It requires complex interconnections between various pieces of overlapping financial information which can result in the errors in spreadsheets. Despite its complexity, when done correctly, it reveals vital information so the buyers or existing entity can make an informed decision.
Although these are very simplistic explanations of common financial models, they give insight into the types of areas that models can be used to explore. From the simple to the complex, the team at Joorney knows how to create and guide you through the financial models you need to determine how much capital you require, the best funding mix for your business, or to make crucial business decisions. Joorney’s financial modeling service can help you address these questions, prepare the types of models above, and much more.