10 Types Of Financial Models: Overview & Uses

Did you know that the concept of financial modeling began in the ancient period? Ancient traders and merchants employed a variety of methods to manage their money. The Babylonian kingdom is home to one of the oldest examples of financial modeling when traders used clay tablets to keep track of loans, interest rates, and payments. They used this information to monitor their financial success and make investment decisions in the future.

Financial modeling developed over time to incorporate methods such as option pricing models and discounted cash flow analysis employed in current finance. Every financial model has a unique structure and is made for a specific requirement. Financial models provide detailed information about a company’s perspective on finances and try to simplify the intricacies associated with them. In this blog, we will talk about the types of financial models, their uses, their importance, and more.

What is Financial Modeling?

The process of developing a mathematical representation of an actual financial situation is known as financial modeling. It includes analyzing and projecting the financial performance of a company, project, investment, or financial asset using a variety of financial instruments and procedures.

An income statement, balance sheet, and cash flow statement are a few examples of financial statements created as part of a financial model. The financial health of the company or project is evaluated using these statements. It also helps to influence decisions about current investments, financing, and strategic planning.

The following fields can benefit from the application of financial modeling:

• Corporate Finance
• Investment Banking
• Private Equity
• Asset Management
• Real Estate

Financial modeling requires software like Excel or other modeling tools, as well as a strong grasp of finance, accounting, and statistics. You can take advantage of various financial modeling courses to get trained in the field.

Also Read: Financial Modeling Examples

10 Types Of Financial Models

Financial models can be either straightforward or complicated depending on the issue. To assist decision-makers in making wise financial decisions, they can use sensitivity analysis, scenario analysis, and other types of financial analysis. Here are some of the important financial models:

1. 3-Statement Model

This model acts as the bedrock for the other models. It gets its name from the 3 financial statements that are part of its structure, namely, the income statement, balance sheet, and cash flow statement. All three statements are connected, thus, even a minor change in any one of them casts its effect on the other two. Although the nature of this model is dynamic, it is user-friendly and can be comprehended easily.

A 3-statement model is used for financial forecasting based on historical data. Some of its other uses are listed below:

• It helps in running business operations smoothly.
• It assists in better management.
• It enables the right budget allocation to different verticals of business.

2. Discounted Cash Flow (DCF) Model

 A DCF model is one of the most important types of financial models. Apart from including everything that comes under the 3-statement model, it takes into consideration the free cash flows after discounting them to the present value using the weighted average cost of capital. As per the needs, the Internal Rate of Return (IRR) can be calculated when making decisions related to an investment.

You can use this model when:

• Raising money for your startup or business.
• Assessing strategic initiatives.
• While valuing a project, investment, or business.
• Making decisions related to internal planning.

DCF model lets you find the current worth of your company based on its future cash flows.

3. Merger & Acquisition (M & A) Model

 A merger and acquisition model helps in analyzing if the merger of two companies would be beneficial. If the union can be valued higher than the standalone value of the individual companies, only then the merger is considered to be logical. This type of model is often used in investment banking and corporate development.

This is considered to be an advanced financial model, which can be used for the following:

• While assessing the impact of an acquisition
• Raising capital
• Portfolio diversification
• Evaluating other merger & acquisition transactions

4. Leveraged Buy-Out (LBO) Model

This type of financial model caters to a deal where high debt financing is used along with a small amount of equity. It comes under the category of an advanced model and includes all the elements of a 3-statement model as well. It also emphasizes operating scenarios, transaction assumptions, and sensitivity analysis as part of its process. An LBO model is generally used in the real estate sector for:

• Valuing a business
• Determining the price of an acquisition
• Getting financing from lenders
• Evaluating sensitivities and scenarios

5. Initial Public Offering (IPO) Model

The IPO model is built to assess the valuation of a company before making a public offer. In other words, an IPO model is used for determining the stock price before listing it in the stock market. Some of its uses are:

• Raising additional capital
• Valuing IPOs
• Increasing brand awareness 
• Attracting new customers

6. Monte Carlo Model

Monte Carlo simulation models employ statistical techniques to simulate several potential outcomes of a choice or investment in the face of uncertainty. Some of the uses of the model are as follows:

• Describe the probability distributions of the unknown variables.
• To run the simulation (typically from thousand to tens of thousand times).
• Analyze the probability distribution of the outcomes after averaging the findings.
• Utilize the findings to inform choices or pinpoint potential danger areas.

7. Budgeting & Forecasting Models

 As the name indicates, a budget model helps the company with its budgeting, for the years to come. Some of the uses of the model are as follows:

• Calculates company expenses and determines the budget requirement of each vertical. 
• Serves the purpose of right budget allocation to all verticals in the business. 
• Uses the income statement of financial planning and analysis.
• It can be categorized as a reporting model and is used to estimate the operating budgets focused on long-term planning.

8. Sum of The Parts (SOTP) Model

SOTP, also known as break-up analysis, is a way of valuing a multi-divisional firm, holding company, or conglomerate. The method’s core is to calculate how much each division would be valued if the conglomerate were split up and spun off or bought by another firm.

•  Break tasks into smaller parts and then completes them. 
• Calculates revenue from smaller segments within a business separately and then adds to determine the total value of the business. Hence, this process is also known as the ‘break-up analysis’. 
• Estimates the value of different verticals within a business or after a company goes through restructuring.

Also Read: Financial Modeling Interview Questions

9. Consolidation Model

A Consolidation Model is built by integrating the financial outcomes of several business units into a single model. The first worksheet of the model is often a summary or consolidation view that displays the highest-level numbers (monthly and yearly sales, profits, expenses, productivity rate, and so on) in the form of tables, graphs, or charts.

• Contains several business units, consolidated for financial modeling and further analysis. When this model is ready, the consolidated data is shown on the first page,
•  Categorized by time period, department, or other verticals of business. 
• This model may appear to be simple, however, it can be quite complex, given the extensive calculations involved.

10. Option Pricing Model

When you want to buy something but find yourself confused because of the uncertainty of the price of an asset, then an option pricing model comes in handy. An ‘option’ generates a right to buy or sell an asset at a price that is predetermined. This option pricing helps you to deal with price fluctuations easily. An option pricing model is used for determining certain probabilities related to the correct price of an option and making changes to existing strategies.

In simple words, it’s a powerful tool for determining the fair market value of an option. Unlike other models, this one is not based on fixed standards. The fact that this model uses different variables to estimate the fair price of an option, makes it mathematical in nature. There are different kinds of option pricing models, of which the Binomial Option Pricing Model and the Black-Scholes Model are the most popular.

Uses of a Financial Model

• Analyzing business growth trends
• Portfolio diversification
• Business valuation
• Periodic variance review
• Making strategic investments
• Forecasting financial trends of a company
• Risk assessment
• Equity research
• Speed up the decision-making process
• Estimating future fund requirements

Apart from the aforementioned uses, a model always comes in handy and helps you shortlist the financing options that would best serve the business so that the others could be ruled out. Along with that, it also deepens your understanding of the entire business altogether.

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Different financial models are needed to address different financial problems and help in making informed decisions. Each financial model has its strengths and limitations, and the appropriate model to use depends on the specific problem statement of the company.

Conclusion

Financial models are crucial tools that investors and corporations use to assess investments, anticipate financial consequences, and make defensible decisions. Each one of the types of financial models analyzes and forecasts financial outcomes using a particular set of presumptions, methods, and inputs. The analysis of historical financial data, the projection of future financial statements using pro forma models, the estimation of an asset’s intrinsic value, the cost of options contracts using option pricing models, and the modeling of uncertain outcomes using Monte Carlo simulation models all make use of models.

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