May 6 ,2017
Financial models are used to evaluate a company’s past or historical performance, to benchmark a company with respect to its peers/ competitors or to estimate/ forecast how the company is going to perform in future. In finance parlance, these are known as Credit Analysis, Ratio Analysis, Equity Research, and Investment Banking etc. In this article, I have covered the major types of financial modelling.
Given an audited financial statement, we need to prepare a financial model by linking all these three statements. Different companies have different styles and approaches to represent their cost-revenue and balance sheet items. While developing this kind of models we need to appropriately classify them under different sections to normalize the company’s biasness to inflate or deflate revenue, profit, cash flow etc.
Banks and other financial institutions use this model to evaluate the historical financial performance of their corporate borrowers.
This model is built upon the three statement models, which is extended further to do three-to-five years of projections, and incorporate other parameters such as future demand growth in the industry, strength & quality of management, quality of collaterals, conduct of the existing loan accounts etc. A credit score is calculated which is a weighted average of financial risk score, management risk score, business risk score, and industry risk score.
When a company applies for loans, the bank uses this model to evaluate the company’s legitimate borrowing potential and the applicable interest rate.
Based on a company’s business profile (such as the geography its operating in, product & service category, target customers etc) and financial profile (size of the company, top and bottom line etc), an analyst need to determine a set of comparable companies. Different types of financial ratios that can be used across this set of companies are PE Multiple, EV/ EBITDA, P/B ratio (Price-to-Book value) etc.
At times we might not have sufficient data available for a company to be analysed, or we want to understand where a company stands with respect to its peer companies, we need to use CCA or Ratio analysis methods.
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