What is Financial Modeling? – Types, Applications, and More

Financial modeling involves the process of developing a mathematical model for the representation of the financial aspect of a project. Companies study various financial statistics to take crucial decisions for the business’s future. 

Whether budgeting the company’s capital or calculating the IRR, a financial model comes in handy in every situation. In this blog, we will talk about what is financial modeling, and its purpose, and also discuss financial modeling and valuation. 

Introduction to Financial Modeling

Developing a financial representation of a corporation or organization, known as financial modeling, is frequently used to predict how well a project or company would do financially. Financial models help to determine investment choices, calculate performance estimates, conduct risk assessments, and create financial projections. Dan Bricklin introduced the concept of spreadsheets, his invention has helped to transform the financial modeling space.

Financial modeling is the strategy to project future financial performance based on historical and current data. It is a sophisticated procedure that requires a detailed review of financial statements, market movements, and other economic indicators to develop financial estimates and evaluate potential risks. 

Importance of Financial Modeling

Financial modeling works as a tool for businesses and individuals to take responsible financial decisions. You can learn more about financial modeling by taking a financial modeling course to help you take better business decisions. Here are some of the reasons why financial modeling is important.

• Making Decisions: Financial modeling enables you to predict the probable effects of various situations, assisting you in making informed choices.

• Budgeting and Forecasting: You can produce precise budgets and forecasts that assist you in making better investment decisions by modeling financial data.

• Investment Analysis: Investment possibilities may be analyzed to determine their potential risks and rewards using financial models.

• Strategic Planning: Financial models can assist companies in developing long-term plans and profitable growth strategies.

• Risk Management: Financial models can assist firms in identifying and managing possible threats to their financial performance by simulating prospective risks and uncertainties.

• Capital Raising: Financial models are frequently used to support capital-raising operations, such as preparing for an IPO or looking for venture capitalist financing.

Types of Financial Models

Broadly, there are 5 types of financial models that walk the ramp:

1. 3 Statement Model: This is one of the most popular financial models. It is prepared using the company’s future income statement, balance sheet, and cash flow statement.
2. Merger Model: When two companies come together to form a new entity via the merger and acquisition process, businesses can predict the revenues, profit margins, cash flows, capital structure, etc. of the newly formed entity using a merger model.
3. DCF (Discounted Cash Flow) Model:  DCF model helps to predict and estimate the cash flows of a company & discount it using appropriate rates. Subsequently, it is used for valuation purposes.
4. Sum of Parts Model:  Calculating the revenue of smaller businesses within the company and then merging them, is referred to as the ‘sum of parts model’.
5. IPO (Initial Public Offering) Model: This model is similar to the DCF model, with an added element of IPO discount. It is used for valuing IPOs and is also related to valuation.

Financial Modeling and Valuation

Financial modeling is about plotting (modeling) valuation data points. Whereas, valuation means estimating the worth of an asset. It is to be noted that value is not the same as price, i.e. it is the benefit a customer derives from the price they paid for an asset. 

Also, the value varies with time, motive, and business. Financial modeling and valuation on the other hand is a broad term that may be subjective. In general, it is used for valuations associated with a company’s finances. Although the entire process of valuation is complex, here are the key sources used to value a business:

• Past Performance: Historical data related to company turnovers, net profits, etc. helps in determining the patterns to predict the future.
• The Current Structure of the Balance Sheet: Using financial ratios can provide businesses with insights into how a business is doing.
• The Current Structure of Future Cash Flows: This helps in calculating the value of a business to its expected growth in the future.

How to Value a company?

Valuations of a company can be extremely useful, especially for startup companies seeking funds or looking to raise capital. A valuation can be calculated based on various financial models. These models take into account the actual cash flow of a company and discount it to the terminal value, to arrive at a valuation. Here are the basic elements of company valuation:

• Intrinsic Valuation: It refers to valuing an asset to its present value in light of cash flows expected from that asset in the future. A Discounted Cash Flow (DCF) model is the best example of this approach.
• Relative Valuation: It refers to determining the value of an asset in relation to its comparable assets, which can be corresponded to some standard variables like sales,  cash flows, etc.
• Contingent Claim Valuation: It refers to measuring the value of assets using option pricing models.

Conclusion

For firms, investors, and financial analysts, financial modeling is an essential tool. Financial modeling uses mathematical and statistical models to assess financial data and assist with budgeting, risk management, and investment decisions. Professionals proficient in financial modeling concepts and methods can make well-informed choices that benefit investors and businesses.