Types Of Financial Models

What Are The Types Of Financial Models?

The different types of financial models are some unique techniques that are commonly used in any business to analyze and forecast the financial performance, which will have a future impact on the entire business operation.

Financial models are used to represent the forecast of company’s financials based on its historical performance as well as future expectations with the purpose of using them for financial analysis and the most common types of financial models include Discounted Cash Flow model (DCF), Leveraged Buyout model (LBO), Comparable Company Analysis model, and Mergers & Acquisition model. These models act as a guide to understanding where the business may stand in the competitive financial market.

Types Of Financial Models Explained

The various types of financial models in excel are some mathematical processes and tools that evaluate and predict the condition of the business going forward, which can be used as a guideline to frame policies and strategies related to finance, marketing and sales, production, pricing, and any other resource related procedures within the business.

Here is the list of the top 4 types of financial models

1. Discounted Cash Flow Model (DCF)
2. Leveraged Buyout Model
3. Comparable Company Analysis Model
4. Mergers and Acquisitions Model

Such models are extremely important for any company because they help in decision making related to different processes within the business. Activities like risk assessment and management, corporate finance, merger, acquisition, portfolio management, budgeting, real estate investment, etc derive their inputs from the analysis made in such models.

These types of financial models in excel are created mainly in excel format or any special software that are available for this purpose. There are various types of inputs used which are derived from historical data and financial statements. Different assumptions, variables, and mathematical formula and equations are used based on some principles to create the model. It is important to maintain the reliability and accuracy of information used and projected in them, which again depends on the skill and knowledge of model creator.

These types of financial models for startups or any other type of business have gained wide important in the financial market due to the ever-changing business landscape which also involves a lot of risk and uncertainty. They help in streamlining the company operations to make it smooth and stable through proper strategies so that it can survive any market downturn.

Let us discuss each one of them in detail as given in the article below.

Top 4 Types Of Financial Models

Given below are 4 different kinds of models commonly used in the financial market. We will study types of financial models for startups or any other type of business in details to understand how they contribute to the business strategies and help in utilising the available resources in an optimum way.

#1 - Discounted Cash Flow Model

This is perhaps one of the most important types of a financial model that is a part of valuation methodologies. It utilizes the projected free cash flows expected to be extracted and discounts them to arrive at a Present Net Value (NPV), which aids in the potential value of an investment and how quickly they can break even from the same.

This can be expressed with the below formula:

DCF =   CF1/(1+r) ¹  + CF2/(1+r) ²      +……..  + CFn/(1+r) ⁿ                                

where CF1 = the cash flow at the end of the year

r = Discounted rate of Return

n = Life of the project

In the NPV calculation, we shall assume that the cost of capital is known for calculating the NPV. The formula for NPV:

,

If NPV is positive, then the project is worth considering; it is a loss-making option.

#2 - Leveraged Buyout Model

A leveraged buyout (LBO) is acquiring a public or private company with a significant amount of borrowed funds. After the purchase of the company, the Debt/Equity ratio is generally greater than 1 (debt constituting a majority of the portion). During the ownership, the firm’s cash flows are used for servicing of the debt amounts and the interest. The overall return realized by the investors is calculated by the exit flow of the company (EBIT or EBITDA) and the amount of the debt which has been paid over the time horizon. This kind of strategy is mostly used in leveraged finance with sponsors like Private Equity firms who want to acquire companies to sell them at a profit in the future.

#3 - Comparable Company Analysis Model

A comparable company analysis (CCA) is a process used to evaluate the value of a firm using the metrics of other businesses of similar size in the same industry. It operates under the assumption that similar companies will have similar valuation multiples, such as the EV/EBITDA. Subsequently, investors can compare a particular company to its competitors on a relative basis.

Broadly the selection criteria for comparable companies can be bifurcated as follows:

Business Profile	Financial Profile
Sector	Size
Products & Services	Profitability
Customer and End Markets	Growth Profile
Distribution Channels	Return on Investment
Geography	Credit Rating

The most integral multiples which are considered for comparative analysis are:

PE Multiple

• PE Valuation Multiple, also known as “Price Multiple” or “Earnings Multiple,” is calculated as :
• Price per share / Earnings Per Share OR Market Capitalization/Net Income
• This multiple indicates the price an investor is willing to pay for each $ of earning.

EV/EBITDA Multiple

• Another common multiple is EV/EBITDA, which is calculated as follows: Enterprise Value / EBITDA
• where EV represents all business (Common Equity + Net Debt + Preferred Stock + Minority Interest).
• This aids in neutralizing the effect of capital structure. EBITDA accrues to both debt and equity holders since it is before the interest component.

Price to Book Value Ratio

• PBV Ratio is the Price/Book ratio is an equity multiple calculated as Market Price of a share/Book Value per share or Market Capitalization/Total Shareholder’s Equity

The steps to keep in mind for executing a comparative valuation are:

1. Pick a group of competitors/similar companies with comparable industries and fundamental characteristics.
2. Calculate the market capitalization = Share Price X No. of shares outstanding

   Ending Equity Value = Exit TEV – Ending Debt = $234mm

   Multiple of Money (MoM) EV return is calculated as =

   The following table is useful for estimating IRR based on five year MoM multiples:

   2.0x MoM over 5 years ~ 15% IRR

   2.5x MoM over five years ~ 20% IRR

   3.0x MoM over 5 years ~ 25% IRR

   3.7x MoM over 5 years ~ 30% IRR

   Thus, we can assume that the implied IRR for the above case is approximately 25% or slightly below the same.

   Example #3

   Comparable Company Analysis Model

   

   • The table above is the comparable comp for Box Inc. As you can see, there is a list of companies on the left-hand side along with its respective valuation multiples on the right-hand side.
   • Valuable multiples include EV/sales, EV/EBITDA, Price to FCF, etc.
   • You can take an average of these industry multiples for finding the fair valuation of Box Inc.
   • For more details, please refer to Box Valuation

   Example #4

   Sample M&A Model - Combined Balance Sheet

   

   Sample Merger Model Scenarios

   

   

   Thus, from the above examples, we clearly understand how the models are created using the historical and current data from the financial reports and used for making projections for the purpose of evaluation and decision making in every business process.

   Recommended Articles

   This article is a guide to what are the Types Of Financial Models. We explain the top 4 types of the same along with examples for each. You can make use of the following resources to learn the basics of Financial Modeling –

   • Financial Modeling Books
   • Alibaba Financial Model
   • Box IPO Financial Model
   • Coursera IPO Model