Financial modeling is a process that uses a company’s historical performance—as well as predicted future performance—to both summarize and forecast its financials.
This process involves the use of key finance, accounting, and business metrics to build complex mathematical models, which ultimately serve as powerful analysis and decision-making tools.
There are many different types of financial models, each with different purposes. Generally, financial models are used to address one or more common goals, including:
Raising capital (debt or equity)
- Capital allocation (efficient distribution of resources)
- Business growth (opening new locations, entering new markets, etc.)
- Projecting growth (of revenues, profits, sales, etc.) Budgeting and forecasting Making acquisitions (hires, businesses, or assets)
- Valuation (of projects, investments, shares of a business, or an entire business)
Ultimately, financial models can be used to help inform investment decisions, corporate transactions, and securities pricing. They can also help inform a company’s decisions regarding budgeting and forecasting, valuation, project prioritization, and resource distribution.
While often created for reporting to internal or external shareholders, financial models may sometimes be confidential to a company (as is the case with budget modeling).
Let’s go over 10 of the most common financial models, including their benefits and applications.
1. Comparable company analysis (CCA) model
Comparable company analysis (CCA) is a method of valuation that operates under the assumption that similar companies will have similar valuation multiples (such as the EV/EBITDA).
The CCA model uses the metrics of other companies of similar sizes in the same industry to come up with an estimate of your company’s value.
One perk of the CCA model is that it doesn’t just help with valuation—it also allows you (and investors) to relatively compare your company’s value to that of your competitors.
2. Discounted cash flow (DCF) model
The discounted cash flow (DCF) model is a somewhat more complex valuation method than CCA.
Considered to be one of the most important types of financial models used in valuation, DCF can be used to value an entire company, shares of a company, or a single project, investment, or cost-saving measure within a company.
Generally speaking, the DCF model is useful for projecting the valuation of anything that impacts a company’s cash flow.
The DCF model works by forecasting a company’s (or investment’s, project’s, etc.) cash flows and discounting them to arrive at a current value (net present value, or NPV). This is what makes DCF so useful: it allows for calculation of current value while also taking into account projections for how much money something will generate in the future.
3. Three-statement financial model
The three-statement financial model is often thought of as the “meat and potatoes” of financial modeling. As its name suggests, this model takes a company’s three major financial statements into account: its balance sheet, income statement, and cash-flow statement.
The three-statement model serves as a standard that provides extensive insight into a company’s financial history and current financial standing.
This model can also be used to assess future performance, as it allows for exploration of how a company will perform under different circumstances and visualization of how certain decisions will interact with each other to impact a company’s financial future.
4. Leveraged buyout (LBO) model
A leveraged buyout (LBO) refers to an acquisition of a public or private company, the majority of which is financed by debt.
In an LBO, the assets of the company being purchased—as well as the assets of the purchasing company—are often used as collateral for the loans and interest. In most cases, the debt/equity ratio following an LBO will be greater than 1.
The leveraged buyout model can be used by the buying company to accurately evaluate the transaction in order to earn the highest possible risk-adjusted internal rate of return (IRR). In this model, the overall return realized by the purchasing party is calculated using the company’s edit flow (EBIT or EBITDA), as well as the amount of debt that’s been paid over the time horizon.
Financial modeling strategies like the LBO model are most commonly used in leveraged finance with investors like private equity firms that seek to acquire companies and later sell them at a profit.
5. Merger and acquisitions (M&A) model
As its name suggests, the merger and acquisitions (M&A) financial model (used most commonly in investment banking and/or corporate development) is used to assess the impact of a potential merger or acquisition. In particular, this model helps calculate the transaction’s impact on the newly formed company’s earnings per share (EPS).
This new EPS can then be compared to the company’s current EPS, helping determine whether the merger/acquisition would benefit its bottom line. If an M&A model forecasts an increase in EPS, the transaction is considered “accretive” (i.e., it will result in growth), while a decrease in EPS indicates that the transaction is “dilutive” (i.e., it will reduce the company’s value).
The complexity of an M&A financial model can vary significantly. In most cases, a single tab model is used for each company involved in the transaction, where the consolidation of Company A + Company B = Company C.
6. Sum-of-the-parts model
Sum-of-the-parts modeling is an approach to valuation that involves valuing a business’ separate units, subsidiaries, or divisions separately, then adding them together for a total value.
This financial model is particularly useful when valuing large conglomerate businesses with many different divisions, as it simplifies the valuation process.
Sum-of-the-parts models are also helpful for determining the individual value of each of a company’s divisions, in case one is acquired or spun off into a separate business.
7. Initial public offering (IPO) model
Initial public offering (IPO) models are perhaps the most read-about financial model, if only because they show up all the time in the financial news. As the name implies, they’re used to value high-profile businesses before they go public.
Commonly performed by investment bankers and corporate development professionals, IPO models involve performing comparable company analysis (CCA) in conjunction with predictions about how much investors will be willing to pay for the company being valued.
The valuation arrived at from an IPO model also includes an “IPO discount,” which ensures that the stock will trade well when it hits the secondary market.
8. Consolidation model
Consolidation models are made by combining the financial data from multiple business entities or subsidiaries within an organization into a single model.
Typically, the first worksheet (tab) in this model is a summary or consolidation view, which sums up the data from the other business units. This primary tab displays the highest-level figures from each unit—including costs, profits, monthly/yearly revenues, productivity rate, and more—in tables, charts, or graphs.
The secondary tabs in a consolidation model show financial data broken down by business unit, department, product line, year, quarter, or month.
The consolidation model is similar to the sum-of-the-parts model in that multiple separate units are added together to create a new, consolidated worksheet.
9. Budget model
As you may have guessed, budget models are used to plan out an operating budget for the coming year(s).
Typically used by Financial Planning & Analysis (FP&A) teams and accounting and finance departments, budget models are usually created for short- to medium-term budgeting, forecasting, and financial planning. They’re commonly based on quarterly or monthly figures and focus heavily on income statements.
Budget models have broad-ranging applications that go far beyond just developing a comprehensive budget, including:
- Financial analysis and forecasting
- Tax planning Labor contract negotiations
- Merger and acquisition analysis
- Capacity planning
- New venture analysis
- Cost-volume-profit analysis
- Market analysis
- Exchange rate analysis
New product analysis
Unlike some other financial models, budget models are confidential to the company producing them and are never shared with external stakeholders.
9. Forecasting model
Also used in FP&A, a forecasting model is used to build predictions that compare to the budget model. In some cases, budget and forecast models are built out in one combined workbook, while in others, they’re created separately.
There are four main types of forecasting models used to predict future expenses, revenues, and capital costs:
Straight-line method: One of the simplest forecasting methods, this involves using historical trends and figures to predict future revenue growth.
Moving average method: A smoothing technique that establishes estimated future values by looking at the underlying pattern of a data set. The most common of these are three-month and five-month moving averages.
Simple linear regression method: A widely used prediction method based on analysis of the relationships between variables (such as ads and revenue).
Multiple linear regression method: Used to forecast revenues when two or more independent variables are required for a projection (such as advertising cost, promotion cost, and revenue).
The bottom line on financial modeling
Financial modeling is an invaluable tool that allows your business to make strategic, well-informed decisions and see the bigger picture when it comes to your finances. Each situation and prediction, however, requires a different type of financial model.
Performing complex analysis using Excel spreadsheets is a thing of the past. At Synario, we go beyond messy, convoluted spreadsheets and utilize built-in formulas, real-time budget and planning projects, and customizable dashboards to help you master financial modeling.
If you’d like to learn more about what Synario can do for your business, let’s talk.