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Understanding financial modeling is essential for any business to make informed decisions. It helps a business in investment analysis, fair value estimation, financial planning, and risk management.
Financial models are data-driven and offer a quantitative analysis of the current position and future of a business.
When it comes to financial modeling, there is no such thing as one size fits all, that’s why there are different types of financial models for different situations.
This post will take you through different financial modeling and provide applications for each one.
What is Financial Modelling?
Financial modeling is a tool that combines key business metrics to create a representation of a company’s financial situation. This helps investors and analysts visualize the current financial position and predict the future performance of a business.
Financial modeling has various benefits, apart from helping make informed decisions it can also help maintain better compliance, assess the potential risks, and identify new opportunities.
This can help make informed decisions during transactions such as mergers, acquisitions, fundraising, etc.
- 3-statement cash flow model
The 3-statement cash flow model provides a detailed view of the cash inflows and outflows. It is mainly used to forecast future financial performance. This business model involves the preparation of an income statement, cash flow statement, and balance sheet. This standard financial model projects the performance of a business over a set period. It is also a common startup financial model to project their future performance.
- Discounted Cash Flow (DCF Model)
This model is used by investors to evaluate the potential profitability and attractiveness of an investment. The DCF model can be used to value shares of a company, specific projects or investments, or anything that may have an impact on the company’s cash flow.
It can use a standalone tool for valuation or in conjunction with other valuation metrics.
- Sum-of-the-parts (SOP) Model
Valuation of a huge conglomerate can be challenging with a single valuation method. This financial model is used to simplify the valuation of large organizations with many divisions.
It values each division or subsidiary separately on their performance and growth prospects. The aggregated sum of the individual segments is added to get the total value of the organization.
The SOP model is suitable in case of spin-offs of a division into a separate company
- Merger & Acquisition Model
This model evaluates the financial consequences of a merger. It analyzes the cash flows and valuations of both companies. The purpose of using the model is to determine earnings per share, impact on cash flows merger, and overall feasibility of the acquisition.
It also helps determine the value of the company and the total acquisition amount to be paid.
Conclusion:
Financial modeling allows a business to make strategic decisions based on data. There are different types of business financial models and each one has a specific application. With each financial model having its specific use, understanding the different types of financial models can help a business choose the best one for its specific situation.
