Types of Financial Model

January 27, 2014

A financial model is a mathematical representation of the financial
operations and financial statements of a company. It is used to
forecast future financial performance of the company by making
relevant assumptions of how the company would fair in the coming
financial years. It is also a risk management tool for analyzing
various financial and economic scenarios and also provided
valuations of assets. These models involve calculations, analyzing
them and then provide recommendations based on the information
gathered. A financial model generally includes projecting
the financial statements such as the income statement, balance
sheet and cash flow statement with the help of building schedules
such as the depreciation schedule, amortization schedule, working
capital management, debt schedule etc. It encompasses the
companys policies and restrictions imposed by lenders that would
impact the financial position.
Investopedia definition of Financial modeling

The process by which a firm constructs a financial

representation of some, or all, aspects of the firm or
given security. The model is usually characterized by
performing calculations, and makes recommendations
based on that information. The model may also
summarize particular events for the end user and
provide direction regarding possible actions or
alternatives

Why Financial Models are prepared?

Financial models helps in conducting historical analysis of a
company, projecting a companys financial performance used in
various fields such as Project Finance, Real estate, Personal finances,
Non-profit organizations, Banks, Oil and Gas projects, Financial
institutions, Government, Investment banking, Equity research etc.
These professional models are predominantly used by the financial
analyst and are constructed for many purposes, such as valuation of
a company/security, determining the benefits/demerits of a takeover
or merger, judging an Initial Public Offer (IPO), forecasting future raw
materials needs for a corporation etc.

Types of Financial Models

There are various kinds of financial models that are used according
to the purpose and need of doing it. Different financial models solve
different problems. While majority of the financial models
concentrate on valuation, some are created to calculate and predict
risk, performance of portfolio, or economic trends within an industry
or a region. The following are the different types of financial models:

1) Discounted Cash Flow model

Among different types of Financial model, DCF Model is
the most important. It is based upon the theory that the
value of a business is the sum of its expected
future free cash flows, discounted at an appropriate
rate. In simple words this is a valuation method uses
projected free cash flow and discounts them to arrive at
a present value which helps in evaluating the potential
of an investment. Investors particularly use this method
in order to estimate the absolute value of a company. If
may want to learn more about Financial Modeling here
2) Comparative Company Analysis model

Also referred to as the Comparable or Comps, it is

the one of the major company valuation analyses that
is used in the investment banking industry. In this
method we undertake a peer group analysis under
which we compare the financial metrics of a company
against similar firms in industry. It is based on an
assumption that similar companies would have similar
valuations multiples, such as EV/EBITDA. The process
would involve selecting the peer group of companies,
compiling statistics on the company under review,
calculation of valuation multiples and then comparing
them with the peer group.
3) Sum-of-the-parts model
It is also referred to as the break-up analysis. This
modeling involves valuation of a company by

determining the value of its divisions if they were

broken down and spun off or they were acquired by
another company.
4) Leveraged Buy Out (LBO) model
Included in the types of Financial model is the LBO
Model. It involves acquiring another company using a
significant amount of borrowed funds to meet the
acquisition cost. This kind of model is being used
majorly in leveraged finance at bulge-bracket
investment banks and sponsors like the Private
Equity firms who want to acquire companies with an
objective of selling them in the future at a profit. Hence
it helps in determining if the sponsor can afford to shell
out the huge chunk of money and still get back an
adequate return on its investment.
5) Merger & Acquisition (M&A) model

Merger & Acquisitions type of financial Model includes

the accretion and dilution analysis. The entire objective
of merger modeling is to show clients the impact of an
acquisition to the acquirers EPS and how the new EPS
compares with the status quo. In simple words we could
say that in the scenario of the new EPS being higher,
the transaction will be called accretive while the
opposite would be called dilutive.
6) Option pricing model
As it is defined Options are Derivative contracts that
give the holder the right, but not the obligation, to buy
or sell the underlying instrument at a specified price on
or before a specified future date. Option traders tend
to utilize different option price models to set a current
theoretical value. Option Price Models use certain fixed
knowns in the present (factors such as underlying price,
strike and days till expiration) and also forecasts (or

assumptions) for factors like implied volatility, to

compute the theoretical value for a specific option at a
certain point in time. Variables will fluctuate over the
life of the option, and the option positions theoretical
value will adapt to reflect these changes.