Financial Modeling – Forecasting Business Performance

Published on 03 Aug, 2017

Today’s fast-changing business landscape has made it imperative to have tools for making informed business decisions, minimizing risks and creating strategic plans. The following article aims to outline the benefits, needs and applications of one such tool – financial modeling. Financial modeling is important for any organization seeking to capitalize on the next level or startup. It helps foresee investing, operating and financing activities that determine the financial position, profitability and risk.

Financial modeling – An Introduction
Financial modelling, wherein Excel sheets are used, is an effective decision making tool to evaluate different business scenarios such as financial feasibility of projects, organizations and businesses. An analyst can use financial modeling to gauge the growth and profitability of a business accurately and help the management make strategic plans based on the predictions.

Benefits of financial modelling
Decision-making: Financial modelling, based on important assumptions, can be used to predict the results of a business strategy. It helps businesses in curbing risks and taking the correct course of action. Company executives use financial models to estimate costs and project profits.

Capital budgeting: Besides financial statement analysis and resource allotment for the next big investment, financial modelling helps in determining the cost of capital. It entails a thorough analysis of debt/equity structure, along with the expected returns for investors.

Monthly assessments: Financial models include monthly assessments and feedback on the actual performance of the company vis-à-vis the predictions under the budget.

Need for financial models
Why would an organization need a financial model? The answer may vary depending on the specific requirement of the business, but can encompass:

  • Managing cash flows
  • Analyzing quality of earnings
  • Examining EBITDA
  • Identifying financial strategy and minimizing risk

Features of a financial model

  • Relevant assumptions: Assumptions should be pertinent and exhaustive, not verbose.
  • Practical values: Financial models can function properly when there are realistic and appropriate quantitative values.
  • Flexible: The model should be flexible enough so that the client has the ability to change the input assumptions. The model users should be able to plug in various numbers into cash flow projections, inventory levels, depreciation schedules, rate of inflation, debt service, etc., in order to run sensitives and scenarios.

Types of financial models
Financial models can vary in type, form and complexity, based on the purpose. These could be a single-sheet model for a quick analysis or a model with various worksheets, or multiple workbook models where various external links are set up for an industry or a company.

Some of the common models are:

  • Three Statement Model
    The most basic setup for financial modeling is a three statement model where three statements – income statement, cash flow and balance sheet – are dynamically linked with formulas. The setup ensures that all the statements are connected, and a set of input assumptions can drive changes in the whole model.
  • Valuation using DCF
    Discounted cash flow (DCF) analysis is one of the most basic methods of valuation. It is used to derive a company’s current value, net present value (NPV), by projecting its future free cash flows. The fundamental behind this model is that the value of a firm is the sum of its forecasted future free cash flows, which are discounted at a specific rate.
  • Leveraged Buyout Model (LBO)
    This model is used when a company finances an acquisition mainly through debt. It helps in estimating if the acquired business can withstand the debt burden and how the business should generate cash flow for an eventual sale and repayment of loan.
  • M&A Model
    The M&A model helps us to understand the impact of the acquisition on the acquirer’s EPS and how the new EPS compares with the current EPS. If the updated EPS is higher, the transaction is called “accretive”, while in the opposite scenario, it would be termed “dilutive”.
  • Comparable Company Analysis
    The financial metrics of a company are compared with those of similar firms in the industry, based on the assumption that similar businesses will have similar valuation multiples, such as P/E, EV/EBITDA and P/BV.
  • Credit Rating Model
    It is largely used by credit analysts to measure the creditworthiness of a business. Based on assumptions regarding future earnings, cost and EBDITA margins, it is determined if the company will have the ability to pay the principal and interest.

Uses of financial models
Financial models are useful in taking decisions related to:

  • Debt or equity fund raising
  • Budgeting and forecasting of business
  • Acquiring business or assets
  • Divesting/selling assets and business units
  • Allocating capital, i.e., investments in projects, business valuation
  • Comparing businesses to their peers in the industry

Aranca in the world of financial modeling:
To support a range of diversified clients, we provide financial modelling services such as cash flow models, market-based/relative valuation models, loan/LBO models, and recovery models. In addition, we build financial models for mergers and acquisitions, structuring and earn out analysis; help in capital structure analysis; and provide due diligence support.

To know more about Aranca’s Investment Research services, please visit:
https://www.aranca.com/investment-research/overview

The importance of financial modelling is mainly rooted in its ability to facilitate prudent financial decisions in an organization. By building financial models, Aranca empowers stakeholders to take better decisions.




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