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.
Three Statement Model:
Three basic statements to understand a company’s financial performance are
- Income Statement
- Balance Sheet
- Cashflow statement.
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.
When to use – Banks and other financial institutions use this model to evaluate the historical financial performance of their corporate borrowers.
Credit Rating Model:
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 to use – When a company applies for loans, the bank uses this model to evaluate the company’s legitimate borrowing potential and the applicable interest rate.
Comparable Company Analysis (CCA) and/ or Ratio Analysis:
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.
When to use – 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.
Discounted Cash Flow (DCF) Model:
It is valuation analysis model that is based on projected future cash flow to assess a company’s worth or value. Future cashflows are to be discounted with an appropriate discount rate (which is dependent of the company’s capital structure and cost of capital) and then sum them up to calculate the valuation.
When to use – Investors use this model to understand the true value of a startup before putting their money and calculate the stake to be bought. Stock market investors use this for fundamental analysis to see if a company is trading higher or lower vis-à-vis its actual worth.
Leveraged Buyout (LBO) Model:
It is also a valuation analysis model but its difference with the DCF model is that LBO takes into account a significant debt financing. The purpose here are three folds – balance sheet adjustment for debt-heavy capital structure, to come up with an acceptable IRR (internal rate of return) and an exit value based on EV/EBITDA multiple.
When to use – When an acquirer company (most of the cases bi bracket Private Equity firms) uses a significant amount of debt to finance the cost of acquisition, we need to use this model to determine the fair valuation and exit-return of the company being acquired which may be private or public.
Merger and Acquisition (M&A) Model:
We need to consider the M&A financing options (eg. Cash, Stock, Debt and Hybrid), share swap ratio, control premium, expected synergy post M&A etc.
When to use – When two companies decide to merge for possible synergy, higher market share, diversification etc or a company decided to acquire another company (eg. Microsoft acquiring LinkedIn), an Investment Banking analyst would this type of models to determine the accretion / dilution.
Option Pricing Model:
These are very complex statistical models and are used by professional option traders. These models take into account few parameters whose values are knowns at present (eg. underlying price, strike price and days to expire of an option) along with forecasts or assumptions on other parameters including implied volatility, to compute the theoretical value for specific options at a given time. Generally, two types of models are used here – Binomial model and Black-Scholes model. Both these models are computation heady and use complex statistical methods.
When to use – Option traders use these models before taking positions on large options and keep on recalibrating the value of the underlying options to understand the value of their options.
Depending on the purpose, requirement and end-use, we can create different types of financial models as discussed above. From situation to situation the complexity of the financial model would also vary. We’ll try to elaborate on each of these models in our subsequent articles.
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