Any company worth its salt uses financial modeling to guide its financial planning and strategic decision-making. Financial modeling offers data-driven, quantitative analysis that tells you where your company stands and where it’s heading.
But one model can’t do it all. As a finance professional, you’ll need different types of analytical models for different situations.
Let’s take a look at the basics of financial modeling and six financial modeling examples that you can use in six distinct scenarios.
What Is Financial Modeling?
Financial modeling involves combining key accounting, finance, and business metrics to build an abstract representation, or model, of a company’s financial situation. This exercise helps a company visualize its current financial position and predict future financial performance.
Financial modeling can be quite handy in a number of situations. It can help inform investment decisions, securities pricing, and plans for corporate transactions such as mergers, acquisitions, and divestitures.
But the most common use of a financial model is for making operational business decisions and performing financial analysis. Executives typically use financial models to make decisions about:
- Budgeting and forecasting
- Organic business growth
- Valuing the company
- Raising capital in the form of debt or equity
- Acquiring new assets or other businesses
- Prioritizing projects
- Distributing the organization’s financial resources
- Divesting or selling assets and business units
Who Builds Financial Models?
With such a broad application, financial models are used by many different types of financial professionals, including:
- Corporate development analysts
- Investment bankers
- Equity research analysts
But in the context of the modern company, those involved in financial planning and analysis (FP&A) are the most likely to be building and using financial models that steer the direction of the company.
The FP&A team plays a crucial role within the office of the CFO. It’s in charge of the company’s financial planning. That means the FP&As are the people creating the budget and performing financial forecasting to help the CFO and other members of senior management understand the company’s financial situation.
Aside from budgeting and forecasting, the FP&A team is also tasked with decision-making support and special projects such as market research and process optimization.
Financial Modeling Makes You A More Strategic Analyst
Companies operating in the twenty-first century are faced with a new set of unique challenges. We now live in a global economy that’s shaped by accelerating innovations in technology. As a result, companies must be agile—poised to make quick, strategic decisions based on the latest incoming data—if they hope to succeed.
And as a financial planner and analyst, you have the opportunity to directly impact your company’s share price. Just take a look at the role of the FP&A team.
To forecast a company’s financials, you must have a deep understanding of both the company’s historical performance as well as key trends and assumptions that might impact its future performance. This also requires an understanding of business operations and accounting.
FP&As visit frequently with nearly every team within an organization, including the treasury and accounting, sales, marketing, operations, and executive management teams. In this sense, the FP&A team acts as a central hub within the company that connects and relays information between the executive and operational teams.
But to play your part—and play it well—financial modeling is absolutely essential. It’s likely the most important weapon in your arsenal. Financial modeling is what gives you the insights you need to make data-driven decisions for your company.
Building a Financial Model
So how do you build a financial model? Many finance professionals choose to build their own financial models from scratch using Excel. Building a financial model this way is no simple task. You’ll need to learn some basic Excel tips and tricks, such as using keyboard shortcuts to increase efficiency. And a little bit of programming knowledge doesn’t hurt, either. Visual Basic for Applications (VBA) is the programming language typically used for Excel and other Microsoft Office programs.
But building a useful financial model takes more than plugging and chugging data and equations. You’ll also need to think about the formatting, layout, and design of your model. For example, separating input (historical data and assumptions) from output (calculations) can help you avoid input mistakes and more easily scan for errors. And a well laid-out and intuitive design will help highlight the main message and key takeaways of your model.
6 Financial Modeling Examples
Financial modeling is an important tool. But one size doesn’t fit all when it comes to financial planning.
You must design your model with a specific question in mind. There are different types of models that FP&As can use depending on the problem they’re trying to solve.
Let’s take a look at six financial modeling examples.
1. Three-statement financial model
The three-statement financial model integrates and forecasts a company’s three financial statements—the income statement, balance sheet, and cash-flow statement—into the future.
The three-statement model represents the real meat and potatoes when it comes to financial modeling. This model acts as a standard that gives a comprehensive overview of the company’s financial history, current standing, and future performance.
It also has predictive power. The three-statement model allows you to explore how your company will perform under multiple circumstances and visualize how different decisions can interact to impact the future of the company.
2. M&A model
The merger and acquisition (M&A) model calculates the impact of a merger or acquisition on the earnings per share (EPS) of the newly formed company. This value can then be compared to the company’s current EPS. The M&A model is useful for helping a company decide whether a potential merger or acquisition will be beneficial to the company’s bottom line.
If the M&A model shows an increase in EPS, then the transaction is considered accretive, meaning it should result in growth. But if the M&A model shows a decrease in EPS, the transaction is considered dilutive, meaning it will reduce the company’s value.
3. DCF model
A financial analyst may turn to the discounted cash flow (DCF) model when they need a way of determining valuation. One of the key attributes of the DCF model is that it calculates current value while taking into account predictions for how much money something will make in the future.
The DCF model can be used to value an entire company, but you can also use this model to value:
- Shares of a company
- A project or investment within a company
- A cost-saving initiative within a company
- Anything that has an impact on cash flow
4. Sum-of-the-parts model
The sum-of-the-parts financial model allows large conglomerate organizations with many divisions to simplify their valuation. As the name suggests, the sum-of-the-parts model values each business unit, division, or subsidiary separately and then adds them all together.
Sum-of-the-parts modeling is a useful tool for determining the value of a company’s divisions in case one is acquired or spun off into a separate company.
5. CCA model
The comparable company analysis (CCA) model is another way for a business to calculate its value. It’s a more basic valuation method than the DCF model.
The CCA model is based on the assumption that similar companies will have similar valuation multiples. It uses metrics from other businesses with similar sizes and operations in the same industry. This gives a ballpark estimation for the value of your company.
6. LBO model
The leveraged buyout (LBO) model is used to analyze an acquisition that finances the cost mostly with debt. The LBO model allows the buying company to properly evaluate the transaction so it can earn the highest possible risk-adjusted internal rate of return (IRR).
Financial modeling represents a key tool for your company’s FP&A team. A good financial model allows you to see the bigger picture and make strategic decisions based on the most up-to-date data.
However, there’s no one-size-fits-all solution when it comes to financial modeling. Different situations call for different types of models.
Model building in Excel can take years to truly master. But you don’t necessarily need to be an Excel whiz or have extensive programming knowledge to build a financial model and plan for your company’s future.
Advanced financial software like Tidemark can help you take the grunt work out of model building. Longview brings speed, agility, accuracy, and automation to your financial planning process. That way, you can spend less time fiddling with formulas in Excel and more time thinking strategically about your company’s next step.