Financial modelling: types

In practice, there are many different types of financial models. We have outlined the
10 most commonly used financial models used by financial modelling professionals.

Three-Statement Model
A three-statement model links the income statement, balance sheet, and cash flow
statement into one dynamically connected financial model. These financial models
are the basis on which more advanced financial models are built such as discounted
cash flow DCF models, merger models, leveraged buyout LBO models, and various
other types of financial models.

It falls under both the categories of financial models: Reporting models and
Integrated financial statement models.

Discounted Cash Flow (DCF) Model

These types of financial models fall under the category of Valuation models and are
typically, though not exclusively, used in equity research and other areas of the
capital markets.

A DCF model is a specific type of financial model used to value a business.  DCF
model is a forecast of a company’s unlevered free cash flow discounted back to
today’s value, which is called the Net Present Value (NPV).

The basic building block of a DCF model is the three-statement financial model,
which links the financials together. The DCF model takes the cash flows from the
three-statement financial model, makes some adjustments where necessary, and
then uses the XNPV function in Excel to discount them back to today at the
company’s Weighted Average Cost of Capital (WACC).

Merger Model (M&A)

The M&A model also falls under the Valuation category of financial models.

As the title suggests, this type of financial modelling is towards a more advanced
model applied to assess the pro forma accretion/dilution of a merger or acquisition.
It’s common to use a single tab model for each company, where the consolidation is
represented as Company A + Company B = Merged Co. The level of complexity can
vary widely and is most commonly used in investment banking and/or corporate
development.

Initial Public Offering (IPO) Model

Like the previous two type to financial models, the IPO model is also a Valuation
model.
Financial professionals like investment bankers develop IPO financial models in
Excel to value their business just before going public. These financial models equate
company analysis with regards to an assumption about how much investors would
be willing to pay for the company in contention. The valuation in an IPO model
includes an IPO discount to ensure the stock trades well in the secondary financial
market.

Leveraged Buyout (LBO) Model

A leveraged buyout (LBO) is a transaction where a company is acquired using debt
as the main source of consideration. These transactions typically occur when a
private equity (PE) firm borrows as much as they can from a variety of lenders (up to
70 or 80% of the purchase price) and funds the balance with their own equity.

An LBO transaction typically requires financial modelling with debt schedules and
are an advanced form of financial models. An LBO is often one of the most detailed
and challenging of all types of financial models as they many layers of financing
create circular references and require cash flow waterfalls.  These types of models
are not very common outside of private equity or investment banking.

When it comes to an LBO transaction, the required financial modelling can get
complex. The added complexity comes from the following unique elements of an
LBO:

 High degree of leverage

 Multiple tranches of debt financing
 Complex bank covenants
 Issuing of Preferred shares
 Management equity compensation
 Operational improvements targeted in the business

Sum of the Parts Model

Another type of financial model that belongs to the Valuation category of financial
models, this model is developed by taking in account a number of DCF financial
models and adding them together. Further, any sundry factors of the business that
may not be apt for a DCF analysis are added to that value of the business. So, for
example, you would sum up, that’s why ‘Sum of the Parts’, the value of business unit
A, business unit B, and investments C, minus liabilities D to arrive at the NAV for the
company.

Consolidation Model
The Consolidation Model belongs to Reporting Model category of financial models. It
includes several business units added into one single model for financial modelling
and further analysis. Typically, each business unit is its own tab, with consolidation
tab that simply sums up the other business units.  This is similar to a Sum of the
Parts exercise where Division A and Division B are added together and a new,
consolidated worksheet is created.
Budget Model
The Budget model is used to do financial modelling in financial planning & analysis
(FP&A) to get the budget together for the next few years, typically in the range of
one, three and five years. Budget financial models are meant to be based on
monthly or quarterly figures and rely strongly on the income statement.

This is one more model belonging to the Reporting model category of financial
models.

Forecasting Model
Similar to the budget model, the forecasting model is also used in FP&A to come up
with a forecast that compares to the budget model. Since it is similar to the
forecasting model, it also belongs to the Reporting model category of financial
models.

The budget and the forecast models are represented one combined workbook and
sometimes they are totally separate.

Option Pricing Model

As the name suggests, this model is part of the Pricing model category of financial
models. Binomial tree and Black-Sholes are the two main option pricing financial
models and are based purely on mathematical financial modelling rather than
specific standards and therefore are an upfront calculator built into Excel.