The financial management of individuals and organizations cannot be better without involving financial modelling issues among others. It assesses a firm’s worth and compares it against other firms on the same market level. Then, what is financial modelling after all?
Finanacial modelling is the mathematical model of a real-world financial situation. It helps look into possible results that will affect decision making. Businesses, investors and financial institutions employ this type of modelling in order to evaluate their exposures and returns.
The domain of financial modelling is not simple as it encompasses many aspects that require thorough knowledge and skills, however it may become effective tool for those who aim for the best investment results.
Types of Financial Modelling
Financial modelling is an essential tool to help businesses make sound decisions. It allows business owners to model out potential financial scenarios to better understand their options and make the best possible decisions. Financial modelling has various types and each comes with its own pros and cons. In this article we will discuss five different types of financial modelling.
Three Statement Model
A three-statement model, also known as a financial model or financial projection is a common type of financial modelling that integrates three key financial statements: income statement, balance sheet, and cash flow statement. This offers an overview of how well a company is currently performing as far as its finances, position and funds flow throughout a particular time frame usually predicting into the future. When creating your projections, be careful to avoid these common financial modelling errors.
Discounted Cash Flow (DCF)
The valuation of a project or asset can be determined using a technique called discounted cash flow (DCF). The principle is that when investing, today’s cash flow values are always greater compared to tomorrow’s cash flows predicted. The future cash flows have risks and therefore, they must be discounted since today’s value equals the summation of all expected future cash flows.
The discounted cash flow (DCF) considers present cash flows, expected future cash flows, and a discount rate in calculating value per share as well as the cost of capital. Many investors who wish to make informed investment decisions also opt for this method. Investors can determine how much they should commit as investments using the discounted cash flow analysis.
Initial Public Offering (IPO)
A private company that decides to sell some of its shares or sell all its shares as one entity in the stock market is known as initial public offering (IPO). This means that it is the procedure by which a business sells additional shares for trading publicly on a stock market.
This type of public offering involves a sale of a company’s shares to retail, or individual, buyers as well as to various institutions. The first step taken by a company before it opens itself up for a sale of its shares to the public.
In most cases, the company announces this because it needs funds for operation and expansion. The company’s stock is subsequently listed in a primary stock exchange hence, opening to the public.
Read Also: Investigating Tax Fraud Through Financial Forensics
Option Pricing Model
An option pricing model is a mathematical model that calculates the theoretical value of an option. It takes into account factors such as the time to expiration, the current price of the underlying asset, the strike price, the volatility of the underlying asset and the cost of carry.
These factors are used to determine the probability of the option either expiring in or out of the money. The price of the option is then calculated using a predetermined formula.
Option pricing models can be used to analyse the impact of changes in the underlying asset prices and volatility on the option prices. They are also used to evaluate the potential profitability of option trading strategies.
Mergers and Acquisition (M&A)
Merger and acquisitions (M&A) are more commonly referred to as the combining of two or more companies as well as the situation whereby one firm acquires another. It normally comprises merging businesses, assets, liabilities, or even acquisition of a firm by another one. In addition, M&A is an umbrella term that encompasses all types of corporate reorganization or restructuring whereby one or more business entities are acquired by another.
Such transactions are mostly meant to expand the market presence, technology capacity, or improve on cost synergies. Corporate strategy drives this and various other parties can be involved including owners, employees, customers, suppliers, regulatory bodies etc and financial gain.
Conclusion
There are a variety of types of financial modelling that can be used to assess a company’s financial performance. Each type of financial modelling has its own benefits and drawbacks. It is important to understand the different types of modelling before making significant financial decisions. With the right approach and tools, financial modelling can be a powerful tool for business owners.