The ability to effectively use financial modelling techniques is vital for organisations looking to gain insights, and drive strategic growth. Effective modelling can provide insights into past, present, and future performance of businesses and investments.
Across industries and scenarios, we use different financial modelling examples to analyse specific aspects of financial data and transactions. It is vital to understand which models to use in which circumstance.
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Why is Financial Modelling Important?
It’s easy to get confused because financial modelling is a broad term that covers many different model types and categories. Some of the terms used to describe or categorise financial models overlap. For example, an LBO model may be a forecast model and a three-statement model and it may deal with actuals. A Project Finance model could be a transaction model or an operational model.
Relax; this guide will help you understand these terms and how they apply to different kinds of models.
Financial Modelling Types
1. Three-Statement model vs Cashflow model
A three-statement model is any financial model that integrates the three primary financial statements: the income statement, balance sheet, and cash flow statement. We sometimes refer to these as a “three-way model”. They provide a comprehensive view of a company’s financial performance, including revenue generation, profitability, asset and liability management, and cash flow generation.
A core financial modelling skill is knowing how to set up a financial model that integrates the three financial statements:
- The cash flow statement shows what payments are moving in and out of the company
- The income statement shows costs and revenues and the resulting profits and losses
- The balance sheet shows the accrued assets and liabilities as cash moves in and out and profits rise or fall.
Check out our free Essential Financial Modelling course to learn how to build an integrated three-statement model.
In comparison, a cash flow model looks at cash flow only. Building a cash flow model is quicker than building a three-statement model. However, it may give a less complete picture of the business’s dynamics. That said, for many purposes, a cash flow model may be good enough for the analysis we want to perform.
2. Forecast vs Actuals vs Budget models
Forecast Models analyse a business’s potential future financial performance. These models help in budgeting, strategic planning, and decision-making by providing insights into revenue growth, expenses, profitability, and cash flows.
Forecasts can be based on historical data, market trends, contractual agreements and other relevant factors. Some forecast models also need the ability to show “actuals.” The word actuals refers to the business’s known historical performance. We usually take this data from the company’s most recent accounts over several years, which then informs how the future forecasts develop.
Generally speaking, the question “What might happen in the future?” sits at the core of what we do as financial modellers. Therefore, most financial models are forecast models.
Note that we are forecasting the future, not predicting it.
We say, “This could happen if X, Y, and X are true.”
We are not saying, “This will happen in the future.”
This is an important distinction.
If I could predict the future, I wouldn’t be writing blog posts about financial modelling. Or maybe I would, but I’d be doing it from the deck of my super yacht.
A common mistake financial modellers make is getting attached to “what the model says” as if it were true.
I often tell trainee modellers: “The only thing you can be certain about what your model is telling you is that it isn’t going to happen the way the model says.”
Since we are forecasting what might happen, not predicting what will happen, scenario and sensitivity analysis is essential in most financial modelling. We examine a range of possible futures to understand what these might look like and what the strategic implications for the business are under those scenarios.
See this chapter of the Financial Modelling Handbook for more on scenario and sensitivity analysis.
Financial Planning and Analysis (“FP&A”) professionals often build models that also consider budgets.
These models have to:
- Analyse and capture company budgets (“what we planned to spend”);
- Compare those planned budgets to actuals (“what we did spend”);
- Use this data to update forecasts (“what we think we will spend in the future”);
- Use those forecasts to update the budgets.
This is a particular skill set and needs a financial model that is appropriately structured to support it.
3. Transaction vs Operational models
Transaction models analyse and evaluate specific transactions, such as mergers, acquisitions, divestitures, or capital-raising activities. They assess the financial impact, risks, and potential returns associated with the transaction and guide decision-makers in negotiating terms and structuring deals.
Operational models focus on the ongoing analysis and optimisation of a company’s operational performance and efficiency over time rather than on a single transaction.
Operational models tend to include actuals and forecasts and require the ability to regularly update forecasts based on revised Actuals as time passes.
4. Deterministic vs Probabilistic models
A Deterministic model uses multiple input variables and calculations to forecast a single future outcome. These input variables can be changed using scenario and sensitivity analysis to examine different possible outcomes, but each time, the model forecasts one single potential outcome.
Probabilistic models, also known as Stochastic models or Monte Carlo simulations, run multiple simulations using random inputs that vary according to specific distributions. These inputs could represent uncertain factors, such as market fluctuations, project timelines, or the behaviour of physical systems. By repeating these simulations many times, these models assess the range of possible outcomes and their probabilities.
We use this method in various fields, including finance, engineering, physics, and project management, to make informed decisions under uncertainty.
5. Valuation models
We use a Valuation model to determine a business’s value. The business may be preparing for a fund-raising event, a sale, or some other transaction that requires the value of the business to be known.
Valuation models typically include Discounted cash flow analysis and/or Comparables analysis.
Discounted cash flow analysis examines a business’s future cash flows and discounts them at an appropriate discount rate, often the Weighted Average Cost of Capital, to determine the present value of those cash flows.
Comparables analysis looks at the value of similar businesses or transactions to determine an appropriate valuation range given relevant market conditions.
Valuation models will typically use several methods to assess the potential value range for the business. We can use this range as a guide in negotiations.
Many of the model types listed below are also Valuation models. For example, Project Finance models will usually also contain discounted cash flow analysis to determine the present value of the cash flows. These give Project Investors an understanding of the returns they will receive from investing in the Project.
6. Initial Public Offering (IPO) models
An IPO model is designed to forecast a company’s financial performance, preparing to go public through an initial public offering. It projects future revenues, expenses, and cash flows, assesses valuation metrics and determines the IPO’s optimal timing and pricing strategy.
IPO models are typically built by investment bankers or corporate finance advisors. So they will typically include the last several years of actuals, as well as a medium-term forecast.
7. Leveraged Buyout (LBO) models
Private equity firms use LBO Models to evaluate the acquisition of a company using a significant amount of debt financing. These models analyse the potential returns to equity investors, considering leverage, cash flows, exit strategies, and risk factors.
A vital requirement of an LBO model is to determine the business’s debt capacity. Like IPO models, LBO models will usually include several years of actuals.
8. Merger & Acquisition (M&A) models
M&A Models evaluate the financial implications of mergers, acquisitions, and other corporate transactions. They assess synergies, valuation, financing options, accretion or dilution in shareholder value, and the overall financial impact of the transaction on the combined entity. Again these are usually built by Investment Banks or Corporate Finance advisors.
9. Project Finance models
Project Finance refers to the financing of infrastructure projects such as wind farms, toll roads or hospitals. Here the cashflow from the asset is used to service the debt raised to support its construction.
It is a highly structured form of financing whereby the often high amounts of leverage are underpinned by tightly negotiated offtake and subcontractor agreements. Project Finance models are often the most complex of financial models and often contain long forecast periods of 25 years or more.
These large projects typically need a transaction model to underpin the pre-financial Close negotiations and support project sponsors, investors, and lenders in determining the financial returns, debt capacity, and pricing of the project.
Because of this, they also often require operational models to monitor the project performance once the construction period is complete and the project has entered the operational phase.
10. Consolidation models
In financial reporting we use consolidation models to consolidate the financial results of multiple entities or subsidiaries into a single set of financial statements showing the combined position of all the parts. These models assess compliance with accounting standards and provide a clear picture of the financial performance of the entire corporate group.
Conclusion
Each type of financial model serves a specific purpose in analysing and interpreting financial data and transactions.
They are not a one-size fits all solution.
By understanding the characteristics and applications of these models, finance professionals and decision-makers can effectively leverage financial modelling techniques to drive informed decisions, mitigate risks, and optimise performance in an increasingly complex and dynamic business environment.
If you want to discuss a financial model for your business, get in touch today.
