Profit maximization and wealth creation are the core premises around which any organization sustains. But how does an organization ensure that the product which it sells or service it renders will stay profitable over time? How will it meet the future debt and product/service delivery commitments with the available resources on hand? Answers to such questions lie in a robust financial model.
Recently, I had an assignment related to the implementation of an end-to-end financial model for an airline company. Based on this experience, I would like to share some important concepts around financial modelling.
What is financial modelling?
The process to combine key financial, operational, accounting and business metrics to build an abstract representation of an organization’s financial performance is what we call as financial modelling.
A financial model is an illustration of organization’s vision for its business – and a working tool that is continuously updated. Whether one wants to minimize expenses, understand how or even where the business needs to grow or simply report on financials, an operational financial model is a key to unlocking business value.
Why is it required?
The most common usage of a financial model is while making operational business decisions and performing financial analysis.
A financial model becomes very important in strategic decision-making such as mergers & acquisitions, securities pricing, investment decisions and so on.
Top management also uses financial modelling while making decisions about:
- Company valuations
- Divesting or spinning-off business units
- Raising capital either through debt or equity
- Distribution of organization’s financial resources
What are the fundamental components of a financial model?
This should include the following:
- Financial and non-financial drivers
- Statement of comprehensive income
- Statement of financial position
- Statement of cash flow
- Weighted average cost of calculation worksheets
- Sensitivity and simulation analysis
- Charts and graphs
What are the different types of financial models?
1. Three-statement financial model – This is the basic model which is a combination of organization’s income statement, balance sheet and cash flow statement. It is a good blend narrating an organization’s historical financial performance, current standing and future growth prospects.
2. M&A model – Financial value that will be created by a potential merger or acquisition is arrived at using this model. The model also determines impact on Earnings per share (EPS) of the merged entity, compares it with EPS of standalone entities and then helps investment bankers whether the M&A transaction is accretive or dilutive.
3. LBO model – Leveraged Buy-Out (LBO) model is used when an investor offers to acquire a company by taking a significant amount of debt and plans to repay the debt with funds generated from the target company or with revenue earned by selling off the target company’s assets. There are three purposes to be solved –adjust balance sheet for debt-heavy capital structure, come up with an agreeable internal rate of return (IRR) and an exit value based on EV/EBITDA (i.e. Enterprise Value / Earnings before Interest, Taxes, Depreciation and Amortization) multiple.
4. Discounted cash flow model – Projected cash flows are discounted with an appropriate discount rate under this valuation analysis model and then summed up to value the company. Discount rates are largely dependent on the company’s cost of capital and its capital structure.
5. Options pricing model - Options are derivative contracts that give the holder the right, but not the obligation, to buy or sell the underlying instrument at a specified price on or before a specified future date. Known factors such as underlying price, days till expiration along with unknown factors such as implied volatility are used to compute the theoretical value for a specific option at a certain point in time under this model.
Summing it up
As we can make out from above discussion, there is no one-size-fits-all solution when it comes to financial modeling. The complexity of the financial model varies depending on the requirements, purpose, end-usage and situations.
In difficult times like these, where COVID-19 has practically impacted every line item of a balance sheet, it has increasingly become important for large number of businesses to have a robust financial model in place. Such a financial model will show their financial position as a going concern and will also be able to demonstrate the COVID-19 adjusted cashflow generating capacity of the business.