Every industry has its jargon and its protocols, and so is the case in the world of financial modeling. There are various types of financial models to choose from. Before using one effectively, you’ll need to understand what each does best, how to read it, and how it might be used in your business planning process.
There are many financial models, each with its purpose and caveats. If you’re not being careful, you could end up using one inappropriate for your needs and thus get entirely wrong results. Numberly will walk you through the types of financial models and how to select the right one for your business’s needs.
Financial models come in all shapes and sizes, but they all serve the same purpose – to help you make better business decisions. If you’re confused about which financial model to use in your business, Numberly can assist you on how and which model can help you reach your goals.
Before delving into the different types of financial models, it’s essential to understand what a financial model is. A financial model is a business process that helps you know how a startup, business, or project will perform financially. This can be used to analyze the profitability of a new product, the viability of a new business, or the potential return on investment (ROI) of a new project. There are many different financial models; the right one for you will depend on your specific needs.
Although financial models may look complicated, they’re actually relatively simple. The purpose of a financial model is to allow you to assess potential returns on your investment. A financial model will show how much revenue your project or business could generate and how much money it could earn in profit. In short, a financial model allows you to determine whether a project or company has a positive ROI.
Here’s a breakdown of the financial models you’re likely to encounter as you advance your career and some advice on selecting the right one for the job at hand.
1) Consolidation Model
So, here we go with our first model – The consolidation model is a type of financial model used to forecast the financial statements of a company by combining the financial statements of its subsidiary companies. Investors and analysts often utilize this type of model to get a better understanding of a company’s overall financial picture. For example, an investor could use this model to see if one of a company’s subsidiaries has been making up for losses in another area of the business. However, consolidation models are typically complicated and time-consuming, so they are best left to professionals who understand them well.
2) Discounted Cash Flow Model (DCF)
A Discounted Cash Flow Model (DCF) is a financial model used to value a company. The model has based on the premise that the value of a company is the sum of all its future cash flows, discounted at a rate that reflects the riskiness of those cash flows.
There are two types of DCF models down below.
- Equity valuation – Equity valuation models focus on the value of a company’s stock.
- Enterprise valuation – while enterprise valuation models focus on the entire company’s value.
To select the right DCF model, you first need to identify your purpose for valuing a company. Are you looking to value a publicly-traded company’s stock? Or are you looking to value a privately-held company?
3) Forecasting Model
A forecasting model is a quantitative model that generates predictions about future events. This model is often used in business to predict future sales, expenses, and production levels. Selecting the suitable forecasting model can be tricky, but luckily there are a few different types to choose from.
- The first type of forecasting model is the trend projection model. This type of model projects future values by extrapolating from past data points. To use this type of model, you need to have historical data that you can use to identify trends.
- The second type of forecasting model is the causal model. This type of model uses cause-and-effect relationships to generate predictions.
4) Budget Model
A budget model is one of the most basic types of financial models. This model projects future income and expenses and can be used to track whether or not an organization is on track to meet its financial goals. This model is typically created using historical data and can be adapted as new information becomes available.
Selecting the right type of financial model depends on the specific needs of your business. If you’re just starting out, a budget model may be all you need. As your startup grows, you may find out that you need a more sophisticated financial model to track your progress.
5) Leveraged Buyout (LBO) Model
In a leveraged buyout (LBO) model, a company is bought out by another company using a large amount of debt. The new company then uses the cash flow from the business to pay off the debt. This type of model is often used in hostile takeover situations. It’s also typically employed when an acquiring company wants to diversify its portfolio or when there are tax benefits associated with taking on more debt.
6) Initial Public Offering (IPO) Model
The IPO model is used to value a company at the time it goes public. This model considers the amount of money raised in the offering, the number of shares outstanding, and the price per share. The model also considers the company’s expected growth rate and estimates the value of the shares using a discount rate.
7) Merger and Acquisition (M&A) Model
The M&A model is used to value a company that another company is acquiring. This model considers the purchase price, the number of shares outstanding, and the company’s expected growth rate. The model also considers the synergy between the two companies and estimates the value of the shares using a discount rate. Finally, the model outputs the present value of the combined company. This type of model is typically used in M&A transactions. It can be helpful if you are an investor who wants to estimate the potential value of a potential acquisition target or seller.
8) Option Pricing Model
This type of financial model is used to value options or derivative securities. Option pricing models use a variety of factors to arrive at a price for the option, including the underlying security’s price, strike price, volatility, time to expiration, and interest rates.
9) Black-Scholes model
The popular and common option in the pricing model is the Black-Scholes model. When selecting an option pricing model, you should consider the most important inputs to you and your company. For example, if you are valuing a call option on a stock with a known expiration date and known volatility, then the Black-Scholes model would be a good choice.
An entrepreneur is someone who has a vision for something and wants to create. – David Karp, Tumblr founder and CEO
Which financial model is right for you?
If you’ve ever wondered what the difference between those financial models is and how to choose the right one, here’s your answer. What works for one startup might not work for another, but several factors go into making the decision about which model to use. Here are some of the most important things to remember when deciding which financial model to use for your startup and why each model is appropriate under certain circumstances.
Step 1: Define Your Revenue Stream
The first step in selecting the suitable financial model for your startup is to define your revenue stream. This will help you identify what type of model will work best for your business. For example, if you’re selling a product, you’ll need to consider how much each unit will cost and how many you expect to sell.
Step 2: Account for Expenses
Every business has expenses, and your startup is no different. Before you can select a financial model, you need to account for all of your potential expenses. This includes one-time costs like legal fees and incorporation expenses, as well as ongoing costs like rent, salaries, and marketing. Once you have a clear picture of your expenses, you can start to look at different financial models and see which one makes the most sense for your business.
Step 3: Determine Profit Margin
The next step in determining a financial model is understanding your startup’s profit margin. This will help you determine how much revenue you need to generate and how much you can spend on expenses. To calculate your profit margin, divide your total revenue by your total expenses. For example, if your startup has a total revenue of $100,000 and total expenses of $80,000, your profit margin would be 20%.
Step 4: Look at the Product Cycle
In order to make money, your startup will need to generate revenue. To do this, you must first create a product or service that people want or need. Then, you must get that product or service into the hands of your customers. Once you have customers, you can begin to generate revenue. Finally, you must reinvest that revenue back into your business in order to continue growing.
Step 5: Set a Target Price
The price you set for your product or service will have a direct impact on your business model. If you’re selling a product, you’ll need to consider the cost of materials, shipping, and any applicable taxes. If you’re providing a service, you’ll need to think about how much it will cost you to provide that service. Keep in mind that you’ll also need to set a target profit margin to make money!
Step 6: Assess Costs & Value Proposition
You need to understand all of the costs associated with your product or service, including materials, labor, shipping, and any other associated expenses. This will help you determine your pricing and profit margins. Additionally, you must be clear on your product or service’s value. What problem does it solve? How does it make your customer’s life better? Answering these questions will help you create a strong value proposition and to determine the perfect and suitable financial model for your business.
After accounting for all these steps, you can determine which financial model will serve your start-up best. Considering the pros and cons of each model will also help you get to make the decision as well. For example, Numberly experts have hands-on experience in making ways clear for its clients towards success. You can reach out by scheduling your first free 15 minutes free consultation call.
Good Luck!
