Top 4 Types of Financial Modelling

Types of Financial Modelling
Types of Financial Modelling

All of us would love to have a few wishes in our lives, but as an entrepreneur you can get the next best thing. Financial modelling can serve as a proverbial genie in a bottle. Okay, maybe it’s not magical but having a sound model in place can make it much easier to accomplish all of your business goals. You can get everything you ever wanted from it.

  • Forecast revenue for your business so that you can make better decisions.
  • Look closely at competitor’s projections to determine areas where you might be able to invest.
  • Translate historical data into growth forecasts.
  • Assess financial viability of new projects.

All of these are important roles that financial modelling play but each role requires a specific type of financial model. So this post is dedicated to taking a closer look at the top 4 models.

#1: Discount Cash Flow Analysis

Discounted Cash Flow (DFC) analysis is the most common method that businesses use to figure the valuation of their company. It provides a value known as the “net present value,” which is just a technical term used to describe a company’s current value. It uses forecasting of future cash flow to determine this.

DFC analysis is used by equity research firms to decide whether a potential investment is overvalued or undervalued. Since this method requires future projections, it’s usually reserved for large businesses since they tend to have more reliable growth rates.

#2: Leveraged Buyout Model

A leveraged buyout model (LBO) is used when an investment firm uses a specific combination of cash equity and debt to buy a company with the intention to sell in 3-5 years down the line. The amount of debt is generally quite high in this case so an LBO is essential to determining whether the required return can be generated during the exit phase.

There is a lot of debt involved with LBO so it’s important for financial modelling to be used to determine whether the operation has the potential to generate stable profits.

#3: Sum of the Parts Model

Some businesses will have several different segments that are so different from one another than it’s impossible to use a single model to value the entire company. An example of a segmented company would be WalMart. They specialise in so many different markets that there is no way a single financial model would cut it. They have automotive, grocery, and retail segments – none of which are comparable, so sum of the parts modelling is required because each valuation method would be different.

Sum of the Parts (SOTP) modelling is also used during mergers and when businesses spin off. Basically, any time that a single valuation method does not work across the board, then SOTP modelling would be required.

#4: Credit Rating Model

This type of financial modelling is used to prove that your business is worthy of getting credit from a lender. For businesses that already have debt, then that is factored into this analysis. Credit Rating Modelling (CRM) shows whether a business has the cash flow to honour payments required of taking a loan.

While CRM is used by lenders to determine whether they should lend money to a business, it’s still a good idea to use this modelling as a guide to making important decisions moving forward.

78% of small businesses fail due to lack of a well-developed business plan. Business planning requires a sound financial model.

Knowledge is the true secret to mastering these financial models. Depending on the purpose of the analysis, your financial models will be different. If you plan on growing your small business into the next industry leader, then you will have to master financial modelling.