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Detailed guide to the financial modeling definition and its types

Detailed guide to the financial modeling definition and its types
Detailed guide to the financial modeling definition and its types

Mergers and acquisitions are complex financial transactions with numerous levels and stages. With that in mind, the M&A community aims to provide business leaders and company executives with the most relevant M&A insights, as well as assist them in conducting complex M&A deals for the first time. 

The following article prepared by the M&A community covers financial modeling as part of M&A deals. 

By the end of the reading, you’ll know the definition of financial modeling and its types, discover industry-specific financial models, and learn the main financial modeling tools. Besides, the article provides financial modeling examples that demonstrate what a financial model of a particular type includes.

What is financial modeling: Basics of financial modeling

Financial modeling is a process of building a numerical illustration of a company’s financial activity in the past, present, and forecasted future. Financial models are usually spreadsheet-based.

Financial models are often used as decision-making tools when a company’s executives expect to assess a new project or acquisition’s potential costs, risks, and profits.

Financial modeling and valuation also aim to decide on budgets, allocate corporate finance resources, define the cost of upcoming projects, and forecast the impact of a specific future event on the company’s stock.

Below are the key components of financial modeling:

  • Assumptions and drivers
  • Income statement
  • Charts and graphs
  • Cash flow statement
  • Sensitivity analysis
  • Balance sheet
  • Supporting schedules
  • Valuation

What is financial modeling used for?

Executives of a target company opt for financial modeling to decide on:

  • Capital allocation
  • Financial analysis
  • Selling business units and assets
  • Growing the business organically (entering new markets, exploring new locations, opening new stores)
  • Planning potential cash flows for upcoming years
  • Valuing the business
  • Management accounting
  • Making acquisitions
  • Raising capital

Types of financial modeling

Professionals outline many types of financial modeling, but let’s define the 10 most frequently used by financial analysts.

#1. Three-statement 

This is the basic financial modeling setup. Such financial models always include three financial statements: income statement, balance sheet, and cash flow statement. There are also supporting schedules. As a rule, these financial statements are dynamically linked to Excel files.

With these financial models, you can plan your company’s expenses and revenue. 

  • The income statement includes particulars about the revenues, expenses, and taxes of a target company over some time as well as its net income.
  • The balance sheet showcases the company’s resources or assets that are to deliver benefits in the future.
  • The cash flow statement presents the reconciliation between net income and generated cash.

#2. Discounted cash flow (DCF) 

Discounted cash flow analysis builds on the three-statement financial model. It calculates the value of a target company and its free cash flow based on the net present value (NPV) of the business’s future cash flows.

By opting for discounted cash flow analysis, the company’s owners can find out whether its stock is undervalued or overvalued. This type of financial model is usually used in equity research and other capital market areas. 

DCF modeling determines the attractiveness of the potential investment opportunity.

#3. Merger and acquisition (M&A)

M&A financial models are used to forecast the profits or losses of a potential merger or acquisition. It primarily aims to figure out the effect on the earnings per share (EPS) of the combined company after closing the deal.

If EPS increases as a result of the merger, then the deal is considered accretive. And if EPS decreases, the transaction is regarded as dilutive.

When building financial models of this type, financial analysts generally use a single tap model for each company, where Company A + Company B = Merged Co.

Investment banking or corporate finance specialists usually build financial models of M&A type.

#4. Initial public offering (IPO)

An IPO financial model is used when a company wants to assess its business in advance of going public. Such financial models aim to make a comparative analysis of the company and assume the cost potential investors would be willing to pay for it. 

The assessment in an IPO financial model includes an IPO discount to ensure good stock trading in the secondary market.

The IPO financial model is frequently used in the sphere of corporate development and investment banking.

#5. Leveraged buyout (LBO)

In a leveraged buyout deal, one company acquires another company with borrowed (debt) money. Due to this, LBO financial models are more advanced and usually are built on complex formulas. 

This financial structure always requires modeling a complicated debt schedule. Its main goal is to figure out the amount of profit a certain company can generate from such a deal.

LBO financial models are rarely used outside private equity and investment banking industries.

#6. Consolidation

The consolidation type of financial modeling suggests multiple businesses uniting into one single model.


As a rule, this financial model includes a separate tab for each business, with a consolidation tab that simply sums up all organizational units. 

The consolidation financial model allows for calculating the possible revenue growth after companies’ consolidation.

#7. Budget

The budget financial model aims to forecast the company’s budget for upcoming years. 

Budget financial models imply the analysis of the company’s figures over the last month or quarter and target the income statement mainly.

Budget modeling helps to better understand your company’s financials and, thus, plan the budget for the upcoming period more effectively. That’s the main reason for this financial model usage.

#8. Forecasting

The forecasting financial model is often combined with the budget financial model, as they have a similar goal: to compare budgets and make forecasts for the upcoming year (or years). 

It’s usually used in financial planning and analysis and helps specialists to understand the company’s attractiveness to potential investors.

#9. Option pricing

Option pricing models aim to define the theoretical value of an options contract. This financial model is based on mathematical formulas and complex calculations and is basically a straightforward calculator built in Excel files. It’s mostly used by investors to determine the true value of an option.

There are three types of option pricing financial modeling:

  • Binomial. This model diagrammatically presents possible prices during different periods and uses either a two-period binomial tree or a multi-period binomial tree. The binomial financial model is mostly used to value American options.
  • Black-Scholes. This financial model operates on five input variables: strike price, volatility, risk-free rate, underlying asset price, and expiration time. It’s mostly used to value European options.
  • Monte Carlo simulation. This model usually includes the application of integration, optimization, and probability distribution. Worldwide investors and financial analysts use it to evaluate the probable success of upcoming investments.

#10. Sum-of-the-parts

A sum-of-the-parts financial model presupposes taking several DCF models and summing them up. 

This is especially advantageous when valuing a huge conglomerate. Financial analysts value each unit separately and then add them together to get the valuation of the whole conglomerate.

This financial model helps to understand the true value of the company, which is especially important in investment banking. 

Financial modeling for different spheres

Besides the 10 common types of financial models described above, there are also industry-specific types of financial modeling. 

Let’s shortly review the main industries where financial modeling is used.

Real estate

In real estate financial modeling, you analyze the property from the Equity Investor (owner) and Debt Investor’s (lender) point of view. 

Commercial real estate aims to determine whether the property is worth investment and project possible risks and potential returns.

Real estate financial analysis is purely based on cash flows.

Private equity

Private equity financial modeling usually aims to assess the return profile of purchasing a business and consists of leverage buyout financial models.

The main metrics of private equity financial modeling are debt/equity ratio, cash on cash return, net present value, internal rate of return (IRR), and debt/EBITDA ratio.

Venture capital

Venture capital financial modeling implies creating venture funds. Modeling venture funds usually implies two models:

  • Model for the fund (the entity that will make investments)
  • Model for the management company (the entity that will manage the fund)

In a venture capital financial model, venture capitalists expect to see the company’s financial situation over more than a year.

SaaS financial modeling

Financial modeling valuation for SaaS companies is a crucial stage of the growth plan.

SaaS businesses typically come with high costs at the early stage. This is because a SaaS product needs to attract lots of new customers from the very start, and this always comes with high spending. 

The SaaS financial modeling includes a review of the business’s revenues and expenses, as well as forecasts on future revenue and important KPIs.

The key elements of the SaaS financial model are:

  • Profit and loss statement or income statement — demonstrates expenses and profits before taxes
  • Revenue model — demonstrates the revenue at the end of every month
  • Unit economics — calculates the profitability of each business unit

Investment banking

Investment banking financial modeling is used to evaluate the company’s present financial performance as well as forecast its future performance.

Financial modeling investment banking allows deciding on the potential investment.

Mergers and acquisitions

M&A financial modeling is often a part of the due diligence process. It aims to determine the potential firm’s cost of the upcoming merger or acquisition by evaluating possible profits and losses. 

An advanced financial modeler in the M&A industry typically chooses such types of business financial modeling as comparable company analysis, three-statement modeling, and DCF financial model.

Startups

As a rule, financial modeling for startups is done to forecast the emerging company’s capital costs, expenses, employees, customers, and revenues.

Financial modeling for start up helps to evaluate the viability of the future business and avoid losses or overspending.

Financial modeling tools

The most common and popular tool used for financial modeling prep is MS Excel. It has all the functions financial analysts need when creating a financial model. The main reason for using MS Excel are:

  • It’s particularly affordable for any business type and size.
  • It’s easy to audit.
  • It frequently integrates with other types of financial work done in Excel.
  • It’s easy to use, even at a basic level.
  • It’s flexible and dynamic.

Still, there are specialized software products that make the financial modeling process more efficient and straightforward. Some software tools are:

Financial modeling examples

Below are three examples of financial modeling based on its type.

Three-statement

The screenshot below demonstrates the balance sheet section of a three-statement single worksheet financial model. The model also includes an income statement, cash flow statement, supporting schedules, and assumptions. Each section can be expanded or contracted to view each model separately.

Source: Corporate Finance Institute

DCF

The following DCF financial model screenshot consists of a balance sheet, free cash flow statement, assumptions and drivers, income statement, supporting schedules, and discounted cash flow model sheet. The latter shows historical data and forecasted results.

Source: Corporate Finance Institute

LBO

The leveraged buyout model demonstrates the fully developed financial statements, credit metrics, debt modeling, multiple operating scenarios, cash-on-cash and IRR, and sensitivity analysis.

Source: Corporate Finance Institute

Summing up

Financial modeling is a spreadsheet-based numerical illustration of a company’s past, present, and forecasted financials that helps to evaluate a company’s potential. 

The main types of financial models are:

  • Three-statement;
  • DCF;
  • M&A;
  • IPO;
  • LBO;
  • Sum-of-the-parts;
  • Consolidation;
  • Budget;
  • Forecasting;
  • Option pricing.

There are also such industry-specific types of financial models as real estate, investment banking, venture capital, mergers and acquisitions, startups, and SaaS. 

The main tool financial analysts use for creating financial models is MS Excel. However, there are also modern software products that make the financial modeling process simpler.

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