Every business has at least three financial statements ready and waiting; a statement of comprehensive income, a statement of financial position, and the cash flow statement. As businesses grow, the need for a fourth statement arises, namely, a statement of changes in equity. Each representing a different aspect of the business, collectively these statements come together in the financial modeling system to give a complete view of the organization’s history and predicted future.
These financial models hold great importance for the management of a business, helping them make important strategic decisions. Commonly considered useful for large organizations and businesses, financial modeling is critical to the growth of mid-sized companies, helping them identify their strengths and weaknesses.
Here is a sample of what prepared financial modeling looks like.
Types of Financial Modeling
To understandwhat financial modeling is, we must identify the various financial models. While similar in essence, each performs a different role, representing a different aspect of the company.
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Discounted Cash Flow Model
One of the most widely used and important financial models, the discounted cash flow model measures the cash flow associated with a project. In this model, all associated cash flows are discounted to their Net Present Value (NPV), showing the potential value of an investment. This model can also be used to determine the benefit of breaking even, and how quickly such a feat can be achieved.
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Three Statement Model
This is the most popular, and basic model, the Three Statement Model is used by most financial modeling firms. In this variation, the three basic financial statements are linked to each other using several formulas. The model aims to connect all the accounts to each other, allowing a set of assumptions to change the entire model, identifying the most profitable change.
Companies turn to this model when making big changes, such as the introduction or redundancy of in-house divisions, the hiring or firing of staff, etc. This is especially useful when small companies grow into mid-sized companies and need restructuring.
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Merger Model (M&A)
This is an advanced model used to evaluate the accretion/dilution of a merger or acquisition. This uses the basic formula of "Company A + Company B = Merged Co."
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Sum of Parts Model
This model is usually a sum of several DCF models, wherein additional components (such as marketable securities) are added to the sum value. This calculates the Net Asset Value of the company at any given time.
- Consolidation Model
- Initial Public Offering (IPO) Model
- Leveraged Buyout Model (LBO)
- Budget Model
- Forecasting Model
- Option Pricing Model
Benefits of Financial Modeling
Large companies make extensive use of financial models. However, these models are not limited to big businesses - mid-sized companies can also benefit from the practical use of these models. Listed below are some advantages for smaller companies looking into financial models:
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Used to forecast costs and profits before making any decision, a comprehensive model can help businesses plan their next moves.
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Financial models can provide a clear picture of how the company is performing and what needs changing. Using models like the Three Statement model and the Budget model can then be utilized to allocate appropriate resources to rectify any complications.
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The business’ current value can be determined quickly, especially using the DCF model.
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Structural changes such as mergers, acquisitions, downsizing, expansion plans etc. can be analyzed before making any decisions.
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Rapidly growing small and mid-sized companies can easily analyze and collate their financial ins and outs to determine where their focus is required.
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Outsourced financial modeling can help businesses accurately represent their financial situation to potential investors and clients. Risks in the company’s strategy can be identified and rectified before-hand.
Practical Example of
Financial Modeling
Private equity firms and manufacturing companies rely on extensive use of financial modeling in analyzing their fiscal health and operating feasibility. Their prime focus is on determining their return on investment and the financial impact of the funds that were directed toward marketing, manufacturing, etc.
Using the Three Statement Model, companies are able to identify if an investment is feasible and decide if it is possible to make a profit or breakeven.
However, reality isn't usually so neat and tidy, and many times financial modeling firms are forced to employ a blend of several financial models to help clients with in-depth analyses and projection of their endeavors. One example of such a blend includes an investment and advisory firm based in New York who approached Research Optimus (ROP), offering to build an acquisition model with multiple scenarios. Although an M&A model would have been optimal in this situation, the "multiple scenarios" kicker meant that it had to have a three-statementmodel essence in it as well to predict the feasibility of said investment. Otherwise, the M&A model would have to be made for each scenario separately.
There are a large number of financial modeling firms whose business model relies on companies outsourcing their financial modeling, because of the benefits it holds. Just as these models help administrators of large companies' grow the business, financial modeling also helps mid-sized companies find their footing, allowing them to expand with confidence.