What are financial modelling techniques?

What are financial modelling techniques?

Financial modelling is instrumental in generating cost-effective business ideas and risk management. That’s why it is widely used by companies for budgeting strategy, raising capital and making acquisitions.

This blog post brings you a detailed insight into various financial modelling techniques and how they enable efficient financial decision-making within a firm.

What is financial modelling?

The process of building an abstract representation or model that is in line with a real world financial situation is called financial modelling. It is designed to represent a financial asset’s performance to aid and inform business decisions. Financial modelling includes spreadsheet models, applications for investment analysis, company valuation, forecasting and modelling techniques.

Important financial modelling techniques

Financial models are designed to showcase an organisation’s past and also future financial performance. The best way to design a financial model is through excel modelling as the programme’s tools are able to appropriately forecast a company’s future operations. It is therefore essential to have an in-depth knowledge about excel to build an impeccable model as well as a foundational understanding of cooperate finance and accounting.

There are certain financial modelling techniques that are leading the financial world today which are crucial for an organisation’s financial decision-making process. Here are some of the most widely used and effective financial modelling techniques:

• Historical data: This is instrumental in determining future trends. Since the data collected from past references is going to be the foundation of your future predictions, it is essential that the data collected is credible and accurate.
• Assumptions: Assumptions involve analysing a company’s historical data and coming up with a strategy for building a financial model. While the term suggests that it is merely guesswork, assumptions in financial modelling must be vivid and well-defined. This is because they are used as the ‘drivers’ or ‘inputs’ for financial models of a business while also representing a company’s expectations and realities.
• Colour coding or linkages: Formatting through colour codes is an essential part of financial modelling. Different cells contain values corresponding to different parameters. Colour coding these cells and your financial model can help your colleagues to understand the model more easily.

Types of financial models

There are various types of financial models that are employed to support the financial decision-making of a firm.

Three Statement Model

This finance model uses three basic statements to determine a company’s financial performance. They are:

• Income Statement
• Balance Sheet
• Cash-flow statement

These type of financial models are typically used by banks and other financial institutions to examine the past financial performance of their corporate borrower. However, when the Three Statement Model is implemented, ensure that the parameters and assumptions are categorized in a way that the organisation’s decision to increase or decrease cash flow, revenue and profit is not biased.

Comparable Company Analysis (CCA) or Ratio Analysis

If you need to determine where an organisation stands in comparison to its contemporaries, the CCA model is used. In this model, an analyst determines a set of comparable companies based on their business and financial profile. This profile is evaluated by taking into account the size of the company, top and bottom line and other factors. For the comparison part of this model, financial ratios such as PE Multiple, EV/EBITDA and P/B ratios are used.

Credit Rating Model

The concept of Credit Rating Model is derived from the Three Statement Model and is designed to project data predictions for three to five years. This financial model also inculcates many other parameters such as strength and quality management, collaterals’ quality, future demand growth and conduct of exiting loan accounts. It is generally used by banks when a firm applies for loans in order to evaluate the firm’s credibility in terms of borrowing potential and the applicable interest rate.

Discounted Cash Flow (DCF) Model

The DCF model involves financial analysis based on predictions and evaluations about future cash flow. It is employed to determine an organisation’s worth or value. These type of financial models are generally used by investors, in order to comprehend the actual value of a start-up before they invest capital into it. Stock market investors also use the DCF model to see if a company is trading higher or lower as compared to its true value.

Leveraged Buyout (LBO) Model

This is similar to the DFC model in terms of valuation analysis methods. However, what separates the two is that the LBO model takes debt financing into consideration while rolling out the financial model. The purpose of the LBO model has three layers, which are:

• Balance sheet adjustment or debt-heavy capital structure,
• Coming up with an acceptable IRR (Internal Rate of Return)
• Exit value based on EV/EBITDA multiple

The LBO model is typically used when an acquirer company uses a considerable amount of debt financing to cover the cost of acquisition.

Why take up a course in financial modelling?

Professionals with financial modelling skills are becoming increasingly popular in the business world. This may be due to the growing need for businesses and organisations to make informed and effective financial business decisions while also curbing the risks that may incur that decision.

In today’s age with automation is taking industries by storm, manual financial modelling skills are still an asset. As the demand for finance experts in this field is increasing, the number of finance professionals with expertise in financial modelling is also on the rise.  

Current finance courses include financial modelling in their curriculum to tap into the potential of this growing sector. The digital revolution has changed the way industries work today. With more and more information becoming automated and the volume of information at a constant rise, it is becoming difficult to cope with such complex data and vast amounts of it too! This is where financial management graduates with expertise in finance planning and modelling can step in and come into their own.  

Online finance courses have also become more prominent, helping working professionals to add this skill to their resume.

Premium institutes today are offering on-campus as well as online finance courses, working to train students to bring a wave of effective financial decision-making into the market. London School of Business and Finance (LSBF), a globally recognised university, is offering an executive education course in this domain. If you are interested in taking up this course, you can read more about the Postgraduate course in Financial Modelling they are offering and sign up for it.

Financial modelling skills are an asset that most multinational firms are looking for when hiring financial professionals. Pursuing this course and incorporating it into your expertise will help you enhance your job prospects and better understand the financial dynamics of an organisation.

This text was written by Meghdeep Patnaik and edited by Amelia Hayward-Cole.