FINANCIAL MODELLING

Financial modeling is the task of building an abstract representation of a real

world financial situation. This is a mathematical model designed to represent the
performance of a financial asset or portfolio of a business, project, or any other
investment.

TYPES OF FINANCIAL MODELS

There are many different types of financial models. In this guide, we will outline the
top 10 most common models used in corporate finance by financial
modeling professionals.

Here is a list of the 10 most common types of financial models:

1. Three Statement Model

2. Discounted Cash Flow (DCF) Model
3. Merger Model (M&A)
4. Initial Public Offering (IPO) Model
5. Leveraged Buyout (LBO) Model
6. Sum of the Parts Model
7. Consolidation Model
8. Budget Model
9. Forecasting Model
10.Option Pricing Model

USES OF FINANCIAL MODELING:

 In the finance industry, the value of financial modeling is increasing rapidly.
 Financial modeling acts as an important tool which enables business ideas and
risks to be estimated in a cost-effective way.
 Financial modeling is an action of creating attractive representation of a financial
situation of company.
 Financial Models are mathematical terms aimed at representing the economic
performance of a business entity.
Financial statement analysis

Financial statement analysis (or financial analysis) is the process of reviewing and
analyzing a company's financial statements to make better economic decisions. These
statements include the income statement, balance sheet, statement of cash flows, and
a statement of changes in equity.
Financial statement analysis is a method or process involving specific techniques for
evaluating risks, performance, financial health, and future prospects of an
organization.[1]
It is used by a variety of stakeholders, such as credit and equity investors, the
government, the public, and decision-makers within the organization. These
stakeholders have different interests and apply a variety of different techniques to
meet their needs. For example, equity investors are interested in the long-term
earnings power of the organization and perhaps the sustainability and growth of
dividend payments. Creditors want to ensure the interest and principal is paid on the
organizations debt securities (e.g., bonds) when due.
Common methods of financial statement analysis include fundamental
analysis, DuPont analysis, horizontal and vertical analysis and the use of financial
ratios.
Financial Statements Overview

Financial statements are a useful tool in analyzing your company’s financial position
and performance. They are comprised of four main components, of which the balance
sheet and the income statement are essential. The first item to consider when looking at
a set of financial statements is whether these are external financial
statements or internal financial statements.
External financial statements are issued for external reporting purposes. They are
for investors, tax authorities or other significant partners who require financial
information. External financial statements are normally produced on an annual basis,
although in some cases (including for public companies) they are produced quarterly.
To ensure comparability and consistency, external financial statements are usually
based on Generally Accepted Accounting Principles (GAAP), which has specific
requirements that must be followed.
Internal financial statements are more flexible than external financial statements and
have a higher analytical component. They may report by division, have more detail or
be produced on a more frequent basis (weekly, monthly or quarterly).

A set of financial statements is comprised of several statements, some of which are

optional. If the statements are prepared or reported by an external accountant, they will
begin with a report from the accountant. This will be followed by the two
essential financial statements:

 The balance sheet (sometimes also known as a statement of financial position)

 The income statement (which may include the statement of retained earnings or it
may be included as a separate statement)

The balance sheet and the income statement are usually followed by the cash flow
statement and notes to the financial statements.

Generally, external financial statements are prepared on the accrual basis of accounting,
which means that assets and liabilities are recorded when they are committed to, and
revenue and expenses are recorded when they are incurred (rather than when they are
actually paid).

The balance sheet is the critical “what do we have” statement. The balance sheet shows
what the company owns (assets such as cash, accounts receivable and equipment) and
what the company owes (liabilities such as accounts payable and loans). Any remaining
difference between these two amounts (the assets and the liabilities) shows what
belongs to the owners as their equity interest. These three amounts should always be in
balance (see the fundamental accounting equation). The balance sheet presents a picture
of where the company is at a certain point in time.

The income statement is the “what did we do” statement. The income statement, or
profit and loss statement, shows how the company performed during the course of its
operations for a fixed period of time. It accumulates information over a set period
(typically annually, monthly or quarterly). Key elements of the income
 statement include revenue and expenses. Combined, these numbers yield the net
income (or loss).

Purpose of financial statements

The general purpose of the financial statements is to provide information about the
results of operations, financial position, and cash flows of an organization. This
information is used by the readers of financial statements to make decisions
regarding the allocation of resources. At a more refined level, there is a different
purpose associated with each of the financial statements. The income
statement informs the reader about the ability of a business to generate a profit. In
addition, it reveals the volume of sales, and the nature of the various types of
expenses, depending upon how expense information is aggregated. When reviewed
over multiple time periods, the income statement can also be used to analyze trends
in the results of company operations.

The purpose of the balance sheet is to inform the reader about the current status of
the business as of the date listed on the balance sheet. This information is used to
estimate the liquidity, funding, and debt position of an entity, and is the basis for a
number of liquidity ratios.

Finally, the purpose of the statement of cash flows is to show the nature of cash
receipts and disbursements, by a variety of categories. This information is of
considerable use, since cash flows do not always match the revenues and expenses
shown in the income statement.

As a group, the entire set of financial statements can also be assigned several
additional purposes, which are:

 Credit decisions. Lenders use the entire set of information in the financials to
determine whether they should extend credit to a business, or restrict the amount of
credit already extended.
 Investment decisions. Investors use the information to decide whether to invest, and
the price per share at which they want to invest. An acquirer uses the information
to develop a price at which to offer to buy a business.
 Taxation decisions. Government entities may tax a business based on its assets or
income, and can derive this information from the financials.
 Union bargaining decisions. A union can base its bargaining positions on the
perceived ability of a business to pay; this information can be gleaned from the
financial statements.

In addition, financial statements can be presented for individual subsidiaries or

business segments, to determine their results at a more refined level of detail.

In short, the financial statements have a number of purposes, depending upon who
is reading the information and which financial statements are being perused.

Income Statement and Cash Flow Statement

Definition of Income Statement

The income statement is one of the major parts of the financial statement. It is used to
represent the revenues, gains, expenses and losses from operating and non-
operating activities of the company. When the total revenues (including gains) exceed
the total expenses, then the result would be the net income while if the total expenses
(including losses) exceed total revenues, then the result would be the net loss.

Here operating activities state the activities which are related to the day-to-day
business of the company like manufacturing, purchasing, selling and distribution of
goods and services. Non- operating activities means the activities which are related to
purchase or sale of investments, assets, payment of dividend; taxes; interest and
foreign exchange gains or losses.

Definition of Cash Flow Statement

The cash flow statement is also an important part of the financial statement of a
company. It is used to represent the cash inflows and outflows during the year from
operating, investing and financing activities. The statement reflects the position of
cash and cash equivalents at the beginning and end of the accounting year. It shows
the movement of cash during the period.

Here operating activities include the basic activities of the company like
manufacturing, purchasing, selling and distribution of goods and services. Investing
activities include the purchase and sale of investments and assets. Financing activities
include the issue and redemption of shares or debentures and other financing activities
related to the dividend, interest, etc.

Assumptions and Income and Balance Sheet Equations for

Projections
http://www.planprojections.com/projections/financial-projection-assumptions/

http://www.planprojections.com/projections/revenue-projection-formula/

https://corporatefinanceinstitute.com/resources/knowledge/modeling/projecting-
balance-sheet-line-items/

Forecasting of Financial Statements and individual items

https://corporatefinanceinstitute.com/resources/knowled
ge/modeling/projecting-income-statement-line-items/
Concept of Free Cash Flow
Free cash flow (FCF) is a measure of a company's financial performance, calculated
as operating cash flow minus capital expenditures. FCF represents the cash that a
company is able to generate after spending the money required to maintain or expand
its asset base. FCF is important because it allows a company to pursue opportunities
that enhance shareholder value.