By Ezra Ivy
A financial model represents the financial situation of a business, providing valuable information that is crucial for decision-making. Being very cohesive, financial models can be created using different techniques, each being widely used by organisations for budget planning, calculating the costs of acquisitions, raising capital, and generating cost-effective business plans to expand the business, overall.
If you are growing your business, you will need a financial model that outlines your company’s past financial performance and assumptions about the future, which can be derived from data like your cash flow statement.
Continue reading for an overview of different financial modelling techniques and how they can help you make a sound business decision.
6 Most Used Types of Financial Modelling Techniques
Three Statement Model
This is by far the most basic setup for financial modelling. As the name suggests, it includes three statements—income statement, balance sheet, and cash flow—which are usually used by banks and other financial institutions to look into the financial history of a borrower.
Leveraged Buyout (LBO) Model
Being an advanced form of financial modelling, an LBO is usually the most complex of all techniques. It assesses the value of an LBO transaction where a business is acquired using debt, helping investors earn the highest possible return rate. This model is rarely used outside private equity or investment banking.
Consolidation Model
A consolidation model is obtained by combining the financial results of multiple business units into a single model. These include monthly and annual revenues, profits, costs, and productivity rate. There are three consolidation methods—full consolidation, proportionate consolidation, and the equity method—and what a business will use depends on the strength of the parent company’s influence over its business units.
Initial Public Offering (IPO) Model
Investment bankers and business developers also build IPO models to value their business before going public. These models look at comparable company analysis and make assumptions on how much the investors would be willing to pay for the business ones it goes public and shares can be bought on the stock market.
Budgeting Model
A budgeting model is any quantitative system that helps a business prepare a budget for the upcoming year/s. It is usually based on monthly or quarterly figures and focused on the income statement of the business. Additionally, it also helps an organisation prepare for situations when revenues and/or expenditures are different from the estimates.
Forecasting Model
The budgeting model is often integrated with the forecasting model to provide a better understanding of the overall financial forecast of a business. Whereas a budget guides the spending of a business based on historical performance, a forecast model helps you understand how future scenarios (e.g. economic recessions, fluctuations in sales, etc.) can affect your business and decisions.
While the list does not cover a type of modelling that can help you in any given situation, these methods can cover you in most financial situations. Financial modelling is a way to understand the financial standing and potential of a business. You can use it to assess everything from annual budgets to business expansion and everything in between, enabling you to organise your financial statements in the level of detail you require.
You will want to work with a professional with financial modelling skills to make informed and effective financial decisions while also reducing the risks associated with them.
Which financial modelling technique do you think will help you the most? Let us know your thoughts by leaving a comment below.
