Imagine if you could predict the future of your company. You could avoid pitfalls, make smarter investments, prime the business for growth, and have security. Clairvoyance isn’t the solution, but data analysis can be, and this is exactly what financial models aim to do.
What is a Financial Model?
Financial models use real data to determine value, how companies will perform, and what potential outcomes for any given action are likely to be.
What Types of Financial Models Exist?
There are many different types of financial models that analysts use to help businesses make better decisions. A few of the most common are outlined below.
Strategic Planning Model
Profitable businesses don’t just happen. Whether a small business or a multinational corporation, companies grow and thrive because the person or people running them have vision, actionable insights, and plans. While basic business decisions involving day-to-day operations are at the core of profitability, financial insights matter every bit as much. Because of this, various financial models are used to help a company assess where it is, where it can go, and what might occur if specific steps are taken.
- Free Cash Flow: Is the company making sound decisions that will help it grow with the cash on hand?
- Economic Value-Added: Is a current process or proposed process adding value to the company?
- Asset Management: Are current assets and liabilities being managed effectively?
- Financing Decisions: Is the company borrowing wisely?
- Profitability Ratios: Is the company operating in an efficient manner?
- Risk Assessment and Management: Is the company wisely balancing risk with profitability?
- Tax Strategy: Are company assets structured in a way to minimize tax liabilities? Are financial transactions carried out in the same way?
Discounted Cash Flow Model
A discounted cash flow (DCF) financial model can be used to determine if the current cost of a potential investment is fair based on its anticipated future cash flow. In other words, the analyst begins by determining what the future free cash flow estimates are and then works backwards to see what the present value estimate is. If the asking price of the investment is higher than the present value estimate, it’s usually better to pass on the purchase. On the other hand, equal or greater value can signify it’s a good investment, though there are certainly other factors to consider.
Leveraged Buyout Model
Because most companies don’t have the cash on hand to purchase a new company outright, and those that do often like to keep the cash on hand for operating expenses and other expansion, purchases are frequently made using borrowed money. This is referred to as a leveraged buyout. When a company is considering a leveraged buyout, there are lots of different factors to consider, such as the value of the business being purchased, how much money will be owed on the debt over a period of years, if the company being purchased will generate enough revenue for the purchaser to cover payments on the loan, and more. Various models will be built to suit the purchasing company’s needs, in order to help determine whether making the purchase using borrowed capital is a fiscally wise idea.
Comparable Company Analysis Model
A comparable company analysis, also called CCA or comp analysis, involves comparing a business to its peers for the purpose of identifying its value or getting an idea of the value of its stock price. Models to calculate the value of a company can be straightforward and include basic things like profit margins and growth, but they can also become quite complex, depending on the purpose of the CCA and the industry.
Mergers & Acquisition Model
During a merger analysis, modeling will also be done to determine if the earnings per share (EPS) of the purchasing company will rise or fall, as well as to what degree change is expected. Very simply, if the EPS will rise, the transaction is referred to as an accretive acquisition. If the EPS will drop, it’s called a dilutive acquisition. A dilutive acquisition isn’t always a bad thing if it’s part of a long-term strategy, but ensuring the EPS rises is essential if a merger or acquisition is being done as a strategic means to add value immediately.
Speak with a CredoCFO
Although these general breakdowns may make financial models sound simple, there many variables, and as the saying goes, “Garbage in, garbage out.” In order to make financial models work for your company, you have to know what data truly matters and be well-versed in numerous aspects of business finance. Focus on what you do best: managing the daily operations of your company, and let us help you build a more profitable future. Email me at firstname.lastname@example.org if you would like a consultation on how financial modeling may help you make better decisions!