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Financial Modelling: Objectives

Financial models are used for various purposes including valuing businesses, raising capital, growing businesses, and budgeting. They involve constructing income statements, balance sheets, and cash flow statements that are linked together. Different types of financial models include project finance models, pricing models, integrated financial statement models, valuation models, and reporting models. Project finance models help evaluate infrastructure project feasibility while pricing models establish appropriate prices. Integrated models include linked income statements, balance sheets, and cash flow statements. Valuation models value assets or businesses and reporting models analyze historical financial performance.

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Rohit Bajpai
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441 views

Financial Modelling: Objectives

Financial models are used for various purposes including valuing businesses, raising capital, growing businesses, and budgeting. They involve constructing income statements, balance sheets, and cash flow statements that are linked together. Different types of financial models include project finance models, pricing models, integrated financial statement models, valuation models, and reporting models. Project finance models help evaluate infrastructure project feasibility while pricing models establish appropriate prices. Integrated models include linked income statements, balance sheets, and cash flow statements. Valuation models value assets or businesses and reporting models analyze historical financial performance.

Uploaded by

Rohit Bajpai
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Financial modelling: objectives

Financial models help in steering historical analysis of a company, projecting a


company’s financial performance used in various fields.

These financial models are predominantly used by financial analysts and are
constructed for many purposes. Financial modelling supports the management in the
decision-making and the preparation of financial analysis by creating financial
models.

The following are the objectives of creating financial models:

 Valuing a business
 Raising capital
 Growing the business
 Making acquisitions
 Selling or divesting assets and business units
 Capital allocation
 Budgeting and forecasting

The best financial models offer a set of basic assumptions. For example, one
commonly forecasted line item is sales growth. Sales growth is documented as the
increase, or decrease, in gross in the most recent quarter compared to the previous
quarter. For financial modelling, these are the only two inputs financial models need
to calculate sales growth.

Financial modelling will create one cell for the prior year’s sales, cell A, and one cell
for the current year’s sales, cell B. The third cell, cell C, would be used for a formula
that divides the difference between cell A and B by cell A. This will be the growth
formula. Cell C, the formula, would be embedded into the model. Cells A and B are
input cells that can be changed by the user.

In this case, the purpose of financial modelling and creating financial models is to
estimate sales growth if a certain action is taken or a possible event occurs.

Financial modelling: ten points to follow


Financial modelling is an iterative process. Analysts creating financial models must
chip away at different sections until they are finally able to tie it all together.

Below is a step-by-step breakdown of where they should start and how to finally
connect all the dots.

1. Historical results and assumptions


2. Start the income statement
3. Start the balance sheet
4. Build the supporting schedules
5. Complete the income statement and balance sheet
6. Build the cash flow statement
7. Perform the Discounted Cash Flow (DCF) analysis
8. Add sensitivity analysis and scenarios
9. Build charts and graphs
10. Stress test and audit the model

Financial modelling: categories


There are multiple varieties of financial modelling tools that are exercised, based on
the purpose and need of doing it. Each category of the financial models solve a
different business problem. While the majority of the financial models concentrate on
valuation, some are created to calculate and predict risk, performance of portfolio, or
economic trends within an industry or a region.

The key to being able to model finance effectively is to have good templates and a
solid understanding of corporate finance.

Examples of financial models available include:

Project finance models


When a sizable infrastructure project is being evaluated for feasibility, the project
finance model helps determine the capital and structure of the project. Project
finance is only possible when the project is capable of producing enough cash to
cover all operating and debt-servicing expenses over the whole tenor of the debt.

Loans and the associated debt repayments are an imperative part of project finance
models, since these projects are normally long term, and lenders need to be sure if
the project can bring sufficient cash against the debt. In other words, project finance
model is used as a financial model when the company needs to assess economic
feasibility of the project.

Metrics such as debt service cover ratio (DSCR) are included in this category of
financial modelling and can be a handy yardstick of the project risk, which may affect
the interest rate offered by the lender.

Right at the start of the project, the DSCR and other metrics are agreed upon
between the lender and borrower such that the ratio must not go below a certain
number.

While the output for a project finance model through financial modelling is uniform
and the calculation algorithm is predetermined by accounting rules, the input is
highly project specific. Generally, it can be subdivided into the following categories:

 Variables needed for forecasting revenues


 Variables needed for forecasting expenses
 Capital expenditures
 Financing
Pricing models
This category of financial models is built for the idea of establishing the price that can
or should be charged for a product.

Price is one of the key variables in the marketing mix. There are four general pricing
approaches that companies use to set an appropriate price for their products and
services: cost-based pricing, value-based pricing, value pricing and competition-
based pricing. The cost of production sets the lower limit while the upper limit is set
by consumer perception about the product/service.

The input to a pricing model is the price, and the output is the profitability. To create
a pricing model through financial modelling, an income statement, or profit-and-loss
statement of the business or product should be created first, based on the current
price or a price that has been input as a placeholder. At a very high level:

Units × Price = Revenue

Revenue – Expenses = Profit

However, this category of financial models can be very complex and involve many
different tabs and calculations, or it can be quite simple, on a single page. When this
structure model is in place, the person doing the financial modelling can perform
sensitivity analysis on the price entered using a goal seek or a data table.

Integrated financial statement models


This category of financial models is also known as a three-way financial model.

The three kinds of financial statements included in the financial modelling of an


integrated financial statement model are the following:

1. Income statement, also known as a profit-and-loss (P&L) statement


2. Cash flow statement
3. Balance sheet

Not every category of financial model needs to contain all three types of financial
statements, but many of them do, and those that do are known as integrated
financial statement models.

From a financial modelling outlook, it’s very important that when the financial
modelling for an integrated financial statement takes place, the financial statements
are linked together properly so that if one statement changes, the others change as
well.

Valuation models: This category of financial models value assets or businesses for
the purpose of joint ventures, refinancing, contract bids, acquisitions, or other kinds
of transactions or deals.

The people who build these kinds of models are often known as deals modelers.
Building this kind of financial models requires a specialized knowledge of valuation
theory and using the different techniques of valuing an asset, as well as financial
modelling skills.

When valuing a company as a going concern there are three main valuation
methods used by industry practitioners:

1. DCF analysis
2. Comparable company analysis
3. Precedent transactions

These are the most common methods of valuation used in investment banking,


equity research, private equity, corporate development, mergers & acquisitions
(M&A) and most areas of finance. A common example of these category of financial
models is Initial Public Offering (IPO) Model and Leveraged Buyout (LBO) Model.

Reporting models
These financial models condense the history of revenue, expenses, or financial
statements, like the income statement, cash flow statement, or balance sheet.

Because they look historically at what occurred in the past, there is school of thought
that these financial models are not real financial models. The fundamentals like
principles, layout, and design that are used in financial modelling are identical to
other financial models.

Reporting models are often used to create actual versus budget reports, which
include forecasts and rolling forecasts, which in turn are driven by assumptions and
other drivers.

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