What is a financial model? – Part 1
A financial model is typically built in Excel to forecast a company’s operational and financial performance into the future.
The forecast can be based on the company’s historical performance or it can purely be based on the set of assumptions that the modeler makes about the company’s future.
So, the financial model is essentially an Excel spreadsheet, however, it is highly structured, dynamic, the cells are interrelated, and almost always, there are well-defined outputs of the financial model. Financial modeling is the process of creating financial models, often, in MS Excel.
What is the purpose of the financial model?
There are different types of financial models, dependent on the purpose of why the financial model has been built in the first place. So, we may build the financial models to:
1. Make a decision about investment into a company – the purpose here is to see whether the company’s future performance warrants our investment, whether we will make an adequate return on our investment, and what happens if some of the assumptions made by the modeler are not true (sensitivity and scenario analysis);
2. Raise either equity or debt – similar to the decision to about investing in a company, raising capital is based on the future operational and financial performance of a company and whether the company will be able to attract the necessary equity or whether it has the necessary capacity to raise debt;
3. Value a business – we may value a business for different purposes, because we may want to sell a business, because we may want to invest in a business, or because we may want to assess the performance of a business. Regardless of the valuation’s purpose, we typically build financial models to perform the valuations.
4. Acquire a business – we may build financial models to perform valuation analysis in more complex corporate transactions such as mergers & acquisitions (M&A), and leveraged buyouts (LBO) where we are interested in the performance of the company being acquired under assumptions of significant leverage, and if the company’s future performance merits the acquisition.
Who builds the financial models?
People who are involved in managing the finances of a company, typically, build or interact with financial models. This may be people inside the company, such as business development analysts, treasury specialists, and chief financial officers. Or, it may be outside consultants who help to raise the capital or who provide the capital to a company, such as investment banking analysts, management consultant associates, commercial banking officers, private equity, and hedge funds associates.
What are the different types of financial models?
Well, there are a variety of different financial models out there dependent on the models’ objective. Here, we will provide a brief overview of the most common models that we may have to build working for a private or public company, or working for an investment or commercial bank.
Models build in investment banking – DCF (discounted cash flow), M&A, and LBO models – when investment bankers help companies raise capital / or advise on various corporate / restructuring transactions. Dependent on the stage of the transaction, investment banking financial models can be quick & dirty models, or extensive models.
Financial models built /used by commercial banks, investment funds, and companies’ corporate development divisions tend to be extensive models, typically based on the quarterly or monthly periodicity. The purpose of these models can be diverse:
- commercial banks are interested in the debt capacity of the company and the downside risks;
- investment funds are interested in equity returns (although depending on their investment whether it is equity or debt);
- and corporate development may create models that serve all of the stakeholders, such as financial models for senior management, shareholders, commercial banks, investment funds, or investment bankers.
We will continue with financial models in part 2.
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