What Are The Different Types of Financial Models For Financial Modeling?

Finance

The primary use of the Financial Model of any company is to evaluate the company’s past performance. The data obtained through these Financial Models would be helpful for the experts to estimate the growth and performance of the company in future. Any investor or stakeholder would utilize these models before investing in a company.

There are several types of Financial Modeling being used when it comes to evaluating a company’s performance. Let us have a look at the top 5 Financial Models that are widely used in companies.

Top 5 Financial Models

  1. Three Statement Model

The Three Statement Model is referred to as the most basic one used by the companies. The name itself could tell us that the entire model is based upon three entities namely the income statement, cash flow, and balance sheet. All three entities are dynamically linked with each other through formulas in Excel.

The main objective of this model is to set up all the connected accounts and even a small set of assumptions could bring changes in the entire financial model. A person needs a solid foundation of Finance, Excel skills, and Accounting to link all the 3 financial statements.

When to use?

Financial institutions make use of this model to evaluate the past financial performance of their corporate borrowers.

  1. Credit Rating Model

The Credit Rating Model is also built upon the three statement model. It has been further extended to perform 3-5 years of projections and incorporate various other parameters like strength & quality of management, the conduct of the existing loan accounts, quality of collaterals, future demand growth in the industry, etc. A credit score is based on the weighted average of business risk score, industry risk score, management risk score, and financial risk score.

When to use?

Whenever any company applies for loans, the bank will utilize this financial model for evaluating the applicable interest rate and the legitimacy of a company’s borrowing potential.

  1. Discounted Cash Flow (DCF) Model

The DCF model’s main aim is to assess any company’s value or worth based on the projected future cash flow. The DCF model makes use of the cash flows from the 3 statement model, makes all the necessary adjustments to it, and then utilizes the XNPV (Net Present Value) function in Excel for discounting them back to today as per the Company’s Weighted Average Cost of Capital (WACC).

When to use?

Investors make use of this financial model to analyze the market value of a startup before investing their money and also calculate the stake that should be bought. Stock market investors make use of this model to analyze whether a company is trading higher or lower.

  1. Leveraged Buyout (LBO) Model

A leveraged buyout is an advanced form of financial modeling that typically requires the modeling of complicated debt schedules. Among all the other financial models, an LBO is referred to as the most challenging as well as the most detailed financial model. Several layers of financing create circular references and require waterfalls of cash flow.

When to use?

Usually, private equity firms or banks make use of this financial model for fair valuation and exit-return of the company that is being acquired.

  1. Option Pricing Model

Professional options traders use the option pricing model, which is a pretty complex statistical model. This model takes into consideration several parameters among which certain are the known ones, while some of them are based on assumptions. Some of the known parameters are strike price, days to expire, and underlying price. The other assumptive parameters include implied volatility and computation of the theoretical value for certain options at a given time. Generally, two types of models are used – the Black-Scholes Model and the Binomial Model.

When to use?

Option traders utilize this model before they take a position on any large option, and they keep on analyzing the value of all the options to understand their values.

Financial Modeling can be done through various models, but it will ultimately depend upon the purpose, end-use, and the requirements. The complexity of a financial model would differ based on the situation. Every company possesses a different structure, and its requirements would be different. This is the reason why the complexity of financial models varies.

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