Financial modelling is an important aspect to better manage the finances of individuals and organisations. In the business world, it is used to estimate the value of a company or to compare it with its peers in the related industry. But what is financial modelling actually?
Financial modelling is the process of creating a mathematical representation or model of a real-world financial situation. It is used to evaluate potential outcomes and make informed predictions about the future. This form of modelling is used by businesses, investors and financial institutions to understand the performance and risks of their investments.
Financial modelling is a complex and varied field that requires a great deal of expertise and knowledge but it can be a powerful tool for anyone interested in making the most of their investments.
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: the income statement, the balance sheet and the cash flow statement. It provides a comprehensive view of a company’s financial performance, position and cash flows over a specific period typically projecting into the future.
- Discounted Cash Flow (DCF)
Discounted cash flow (DCF) is an analysis method used to determine the value of a project or asset. It is based on the concept that the projected future cash flows from an investment are worth less than the current cash flows. This is because the future cash flows are associated with an element of risk, therefore to compensate for this, the future cash flows must be discounted to present day values.
The discounted cash flow calculation takes into account the current cash flows, expected future cash flows, the cost of capital and the rate of return. This method is popular amongst investors who want to make informed decisions regarding their investments. By using discounted cash flow analysis, investors can make informed decisions about how much to invest in an asset, or project.
- Initial Public Offering (IPO)
Initial public offering (IPO) is a process by which a private corporation offers its shares to the public for the first time. In other words, it is the process of a company issuing new shares for public trading on a stock exchange.
It is a sort of public offering in which a company’s shares are sold to institutional investors and in most cases to retail (individual) investors.. It is the first step a company takes when it decides to offer its shares to the public.
The company usually makes the IPO announcement in order to raise capital to fund its operations and expansions. Upon successful completion, the company’s stock is listed on the primary stock exchange, thus making it available for public trading.
- 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)
Mergers and Acquisitions more commonly known as M&A refer to the merging of two or more companies or the process of one company taking over another. It usually involves the combination of businesses, assets, liabilities or the complete takeover of an existing company by another. M&A can also refer to any type of corporate reorganisation or restructuring that involves the acquisition of one or more businesses by another.
The purpose of such transactions is often to increase market share, geographical reach, technological capabilities, or cost synergies. M&A is driven by corporate strategy, rather than financial gain, and can involve a variety of stakeholders, such as owners, employees, customers, suppliers, regulatory bodies, and lenders.
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.