A financial model is simply a tool that’s built in Excel to forecast a business’ financial performance into the future. The forecast is typically based on the company’s historical performance, assumptions about the future, and requires preparing an income statement, balance sheet, cash flow statement and supporting schedules (known as a 3 statement model). From there, more advanced types of models can be built such as discounted cash flow analysis (DCF model), leveraged-buyout (LBO), mergers and acquisitions (M&A), and sensitivity analysis. Below is an example of financial modeling in Excel.
Financial Model used for
The output of a financial model is used for decision making and performing financial analysis, whether inside or outside of the company. Inside a company, executives will use financial models to make decisions about:
- Raising capital (debt and/or equity)
- Making acquisitions (businesses and/or assets)
- Growing the business organically (i.e. opening new stores, entering new markets, etc.)
- Selling or divesting assets and business units
- Budgeting and forecasting (planning for the years ahead)
- Capital allocation (priority of which projects to invest in)
- Valuing a business
Who builds financial models?
There are many different types of professionals that build financial models. The most common types of career tracks are investment banking, equity research, corporate development, FP&A, and accounting (due diligence, transaction advisory, valuations, etc).
Here is a list of the 10 most common types of financial models:
- Three Statement Model
- Discounted Cash Flow (DCF) Model
- Merger Model (M&A)
- Initial Public Offering (IPO) Model
- Leveraged Buyout (LBO) Model
- Sum of the Parts Model
- Consolidation Model
- Budget Model
- Forecasting Model
- Option Pricing Model
#1 Three Statement Model
The 3 statement model is the most basic setup for financial modeling. As the name implies, in this model the three statements (income statement, balance sheet, and cash flow) are all dynamically linked with formulas in Excel. The objective is to set it up so all the accounts are connected, and a set of assumptions can drive changes in the entire model. It’s important to know how to link the 3 financial statements, which requires a solid foundation of accounting, finance and Excel skills.
#2 Discounted Cash Flow (DCF) Model
The DCF model builds on the 3 statement model to value a company based on the Net Present Value (NPV) of the business’ future cash flow. The DCF model takes the cash flows from the 3 statement model, makes some adjustments where necessary, and then uses the XNPV function in Excel to discount them back to today at the company’s Weighted Average Cost of Capital (WACC).
These types of financial models are used in equity research and other areas of the capital markets.
#3 Merger Model (M&A)
The M&A model is a more advanced model used to evaluate the pro forma accretion/dilution of a merger or acquisition. It’s common to use a single tab model for each company, where the consolidation where Company A + Company B = Merged Co. The level of complexity can vary widely and is most commonly used in investment banking and/or corporate development.
#4 Initial Public Offering (IPO) Model
Investment bankers and corporate development professionals will also build IPO models in Excel to value their business in advance of going public. These models involve looking at comparable company analysis in conjunction with an assumption about how much investors would be willing to pay for the company in question. The valuation in an IPO model includes “an IPO discount” to ensure the stock trades well in the secondary market.
#5 Leveraged Buyout (LBO) Model
A leveraged buyout transaction typically requires modeling complicated debt schedules and is an advanced form of financial modeling. An LBO is often one of the most detailed and challenging of all types of financial models as they many layers of financing create circular references and require cash flow waterfalls. These types of models are not very common outside of private equity or investment banking.
#6 Sum of the Parts Model
This type of model is built by taking several DCF models and adding them together. Next, any additional components of the business that might not be suitable for a DCF analysis (i.e. marketable securities, which would be valued based on the market) are added to that value of the business. So, for example, you would sum up (hence “Sum of the Parts”) the value of business unit A, business unit B, and investments C, minus liabilities D to arrive at the Net Asset Value for the company.
#7 Consolidation Model
This type of model includes multiple business units added into one single model. Typically each business unit is its own tab, with consolidation tab that simply sums up the other business units. This is similar to a Sum of the Parts exercise where Division A and Division B are added together and a new, consolidated worksheet is created. Check out CFI’s free consolidation model template.
#8 Budget Model
This is used to model finance for professionals in financial planning & analysis (FP&A) to get the budget together for the coming year(s). Budget models are typically designed to be based on monthly or quarterly figures and focus heavily on the income statement.
#9 Forecasting Model
This type is also used in financial planning and analysis (FP&A) to build a forecast that compares to the budget model. Sometimes the budget and forecast models are one combined workbook and sometimes they are totally separate.
#10 Option Pricing Model
The two main types of models are binomial tree and Black-Sholes. These models are based purely on mathematical models rather than subjective criteria and therefore are more or less a straightforward calculator built into Excel.