Financial Modeling Best Practices

What is Financial Modeling?

Financial Modeling is the practice of creating a financial representation of an organization or project by forecasting its future economic performance through a mathematical model.

This type of modeling aims to capture all variables in an event, quantifying these variables and thus creating formulas.

What is Financial Modeling used for?

Financial Modeling is used to perform financial analysis and thus to influence decision-making, whether that be for internal business use, or external. There are many uses for Financial Modeling, some of which include:

• Raising capital (either debt and / or equity)
• Making acquisitions (of entire companies or the assets of an organization)
• Growing the business organically
• Selling or divesting company assets or business units
• Forecasting and budgeting for the organization, in terms of its future financial performance and value
• The allocation of capital, giving insight into which projects need to be invested in
• Valuation of a business

What are the types of Financial Models?

There are numerous kinds of Financial Models, chosen according to context, i.e. for the need and purpose of the model. Here are some examples of financial models:

1) Discounted Cash Flow Model: This model bases itself on the value of a business as the sum of its expected future free cash flows, discounted as appropriate to reach the present value. This model aids investors in estimating the absolute value of the company.

2) Comparative Company Analysis model: Popular in the investment banking industry, this financial valuation model uses comparison with similar businesses operating in the same industry. Analysts collect available statistics for the companies being reviewed and then calculate the valuation multiples for comparison.

3) Sum-of-the-parts model: This Financial Model seeks to value a company by calculating the worth of its aggregate divisions. This provides a variety of values for the equity of a business by accumulating the individual value of each of its business units; this produces a single total enterprise value (TEV). This model is particularly useful to represent the value of businesses with units in multiple industries as valuation methods vary across industries.

4) Leveraged Buy Out model (LBO): A leveraged buyout is the acquisition of a business using a significant sum of money in order to attain the cost of acquisition. The objective of leveraged buyouts is to allow companies to proceed with large acquisitions without the commitment of a lot of capital. An LBO model represents what would happen when a private equity firm attains a company and then sells it in the near future.

5) Merger & Acquisition model (M&A): This model allows insight into the impact of an acquisition on the acquirer's Earnings Per Share (EPS). If the new EPS is higher, then the transaction will be accretive (growth by gradual addition).

6) Option pricing model: This type of model uses fixed data in the present, for example underlying price, alongside predictions or forecasts for factors like implied volatility. This is then used to generate theoretical valuations for a precise option at one time. This model is relied upon by many professional traders and investors to keep track of the fluctuating risk and value of their option positions.

If you'd like to find out more about Financial Modeling, visit these webpages:

Overview of Financial Modeling

Financial Modeling Definition

Financial Modeling Best Practices and Conventions