There are different financial models types used for competitive analysis, to evaluate a company’s past performance and to forecast or predict the future trends. In this article let’s focus on a few common models used in finance by professionals.
Three Statement Model
It is one of the very basic financial models types – used to understand the financial performance of a company. As the name entails, the three basic statements are:
- Income statement
- Balance sheet
- Cash flow statement
Based on the above statements, we need to create a financial model. These three statements are linked with formulas in excel sheet. It is vital to understand how to link all three with particular formulas. Hence, this requires strong finance, accounting and excel skills. Different industries have different styles and approaches to prepare this financial model.
Especially most of the financial institutions like banks use this model to evaluate past performance of their borrowers.
Discounted Cash Flow
This model is based on the above three statement model. This is an essential methodology of measuring the cash flow of the company. DCF is based on projected future cash flow and discounts them to get the Net Present Value (NPV).
The formula is:
If CF1 is cash flow of year 1
CF2 is cash flow of year 2 and so on …
r is the discounted rate of return and n = life of the project then,
DCF = CF1/ (1+r) 1 + CF2/(1+r) 2 +…….. + CFn/ (1+r) n
And Net Present Value (NPV) = Present Value of Cash Inflow – Present Value of Cash Outflow
Such financial models types are used by investors to understand the true value of a business project before investing in that project. Research analysts mainly use this kind of model.
Credit Rating Model
Credit rating model is based on the three statement model. Three statements models get extended to 3 to 5 years of projections along with other elements like future demand growth in the industry, quality and strength of collaterals, conduct of existing loan accounts, quality of management etc.
A credit score is a weighted average of risk scores. It is the calculation of a weighted average of financial risk score, management risk score, business risk score and industry risk score.
This credit rating model is generally used in a loan application. If someone applies for a loan, the bank uses these financial models types to evaluate borrowing potential and interest rate.
Leveraged Buyout Model (LBO)
It is an advanced type of financial model. This model has many layers of financing; so it is more challenging and detailed. LBO transaction requires modelling a complex debt financing. It mainly focuses on three-fold balance sheet adjustments for debt-heavy capital structure. The final result is IRR – internal rate of return and exit value calculation.
As this is an advanced model, it is extensively used in investment banking and private equity.
If someone wants to acquire a company, then this model is used to determine the fair valuation and exit return of the company.
Merger and Acquisition Model (M&A)
This is again an advanced type of financial model used to evaluate merger and acquisition financing options. It evaluates the pro forma of accretion or dilution of a merger or acquisition. This M&A model considers financing options such as stock, cash, debt, swap ratio, control premium, expected synergy post etc.
It is nothing but consolidation of Company A + Company B = Merged Company. The level of complexity varies depending on the type of company.
Merger and acquisition model is used when two companies decide to merge, or one company decide to acquire another one. During the time of mergers, this model will consider market share, possible synergy, diversification etc. M&A model is also used by investment banking or corporate development mavens.
Option Pricing Model
This is one of the most complex financial models. The primary elements of this model are the binomial tree and Black Scholes model. Both of these elements use sophisticated statistical methods. This model considers present values of few parameters like underlying price, strike price; days of expiry etc.
It is purely a mathematical model based on calculations, forecasting and assumptions. Generally, this model is used by option traders to understand the value of their options.
Depending on the purpose, requirement, end-use and situation; the complexity of the financial model would vary.
Stay tuned to space for further details on the financial models types.