Thursday, April 18, 2024

What Are The Types Of Financial Models?

Financial modeling is a numerical representation of a company’s past, current, and predicted future operations. These financial models help the management in making decisions for the firm/company. They could be used by business leaders to estimate the expenses and profitability of a proposed new project.

Financial analysts use them to explain or forecast the impact of events on a company’s stock, which can range from internal elements like a change in strategy or business model to external elements like a change in economic policy or legislation.

Financial models are used to evaluate a company’s valuation or to compare companies to their industry counterparts. 

There are various types of financial modeling. However, with so many financial models it becomes difficult for a common person without any advanced knowledge of accountancy to know about the same. Hence, out of the various types of financial modeling, it is important to know that the Three Statement Model is the most common sort of financial model.

What Is the Purpose of Financial Modeling?

People both inside and outside of firms use financial models for decision-making and financial analysis. Financial models may be created for a variety of purposes, including the need to obtain capital, organically grow the business, sell or divest business units, allocate capital, budget, forecast, or appraise a corporation.

What Information Should a Financial Model Contain?

You should include sections on assumptions and drivers, an income statement, a balance sheet, a cash flow statement, supporting schedules, valuations, sensitivity analysis, charts, and graphs in order to produce a usable and understandable model.

What Kinds of Companies Use Financial Modeling?

Different types of Financial modeling is used by professionals in a range of industries. Here are a couple such examples:

 Bankers utilize financial models like the Three Statement Model for sales and trading, stock research, and both commercial and investment banking, public accountants for due diligence and valuations, and institutions for private equity, portfolio management, and research.

How Do You Validate a Financial Model?

Among the various financial models, it is important to know that financial modeling errors can lead to costly mistakes. As a result, financial models may be given to a third party to validate the information included within it.

 Three Statement Model validation may be requested by banks and other financial institutions, project promoters, firms seeking money, equity houses, and others to reassure the end-user that the calculations and assumptions inside the model are correct and that the results produced by the model are reliable.

Real-Life Illustration

The finest financial models give consumers a set of fundamental assumptions. Sales growth, for example, is a frequently projected line item. The increase (or decrease) in gross sales in the most recent quarter compared to the preceding quarter is recorded as sales growth. A financial model requires only these two inputs to compute sales growth.

The financial modeler constructs one cell for sales from the previous year, cell A, and one cell for sales from the current year, cell B. Cell C is used in a formula to divide the difference between cells A and B by cell A. This is the formula for growth.  In this scenario, the model’s goal is to forecast revenue growth if a specific action is made or a potential event occurs.

Of course, this is only one example of the types of financial modeling in action. Finally, a stock analyst is looking for prospective growth. Comparing firms is very significant when making a stock buying decision. Multiple models assist an investor in deciding between various competitors in an industry.

What is the Three Statement Model?

A three statement model is a type of financial modeling that connects three key financial statements, such as the income statement, balance sheet, and cash flow statement, to create a dynamically connected single financial model that serves as the foundation for more complex financial models such as leverage buyout, discounted cash flow, merger models, and other financial models.

A three statement model is a complicated financial model that incorporates three essential financial statements, such as the income statement, balance sheet, and cash flow statement, and integrates them into a single financial model.

 This model serves as the foundation for further key models such as DCF valuation, merger and acquisition models, and so on. It is also used for sensitivity and scenario analysis.

The primary benefit of these models is that we can capture the fundamentals of three statements in a single excel file. There is a reduced chance of incorrect formula links. When everything is shown in a single excel file rather than three different models, it appears more organized. It also expands the scope of multi-business organization consolidation.

Bottom Line

There are various financial models. In order to study the economic status of any particular firm or company, one should have an understanding the various types of financial modeling. The most commonly known and used financial models is the three statement model. The three statement model is the study of the profit and loss statement, The balance sheet, and the cash flow statement.

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