FINANCIAL

MODELLING
Unit II
TYPES

• Three-Statement Model
• Discounted Cash Flow (DCF) Model
• Merger Model (M&A)
• Initial Public Offering (IPO) Model
• Leveraged Buyout (LBO) Model
• Sum of the Parts Model
• Consolidation Model
• Budget Model
• Forecasting Model
• Option Pricing Model
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PROCESS OF CREATING A FINANCIAL
MODELING
FINANCIAL MODELLING
PROCESS
PROCESS OF CREATING A FINANCIAL MODELING
Any financial model starts with the entry of historical financial statements. The analyst
then inputs the historical information into an excel spreadsheet, which marks the start
of financial modeling. Generally, analysts prefer the latest 3 to 5 years of historical
#1 – Entry of Historical Financial Data data as it provides a fair bit of insight into the company’s business trend in the recent
past. The analyst should be cautious while capturing the historical data from the
three financial statements and the corresponding schedules. Any mistake in this step
can potentially deteriorate the quality of the end model.

In this step, the analyst must apply all their knowledge of accounting and finance. Each line item
of the historical income statement, balance sheet and cash flow statement should be analyzed
#2 – Analysis of Historical to draw meaningful insights and identify trends. For instance, growing revenue,
Performance declining profitability, deteriorating capital structure etc. It is important to note that this analysis
will strongly influence the assumptions for forecasting. Once the trend has been identified, the
analyst should try and understand the underlying factors driving the trend. For instance, the
revenue has been growing due to volume growth; the profitability has been declining in the last
three years owing to a surge in raw material prices; capital structure has deteriorated on the
back of debt-laden capex plan etc.

#3 – Gathering of Next, the analyst has to build the assumptions for the forecast. The first method to draw assumptions is using the
available historical information and their trends to project future performance. For instance, forecast the revenue growth
Assumptions for as an average of the historical revenue growth in the last three years, project the gross margin as an average of the
Forecasting historical period, etc. This method is useful in the case of stable companies. On the other hand, some analysts prefer to
use forecast assumptions based on the current market scenario. This approach is more relevant in the case of companies
operating in a cyclical industry, or the entity has a limited track record. Nevertheless, the assumptions for some of the
line items in the balance sheet, such as debt and CAPEX, should be drawn from the guidance provided by the company
5 to build a reliable model.
 PROCESS OF CREATING A FINANCIAL MODELING
Once the assumption is decided, it is time to build the future income
statement and balance sheet based on the assumptions. After that, the cash
flow statement is linked to the income statement and balance sheet to
#4 – Forecast the Financial Statements using capture the cash movement in the forecasted period. At the end of this step,
the Assumptions there are two basic checks –The value of the total asset should match with
the summation of total liabilities and shareholder’s equity The cash
balance at the end of the cash flow statement should be equal to the cash
balance in the balance sheet

Next, the analyst should create a summary of the output of the final financial
model. The output is usually customized as per the requirement of the end-user.
Nevertheless, the analyst must provide their opinion on how the business is
– Future Business Risk Assessment expected to behave in the upcoming years based on the financial model. For
instance, the analyst can comment that the company will be able to grow
sustainably and service its debt obligations without any real risks in the near to
medium term.

This step aims to determine at what point the performance of the company will start
#6 – Performance of to decline and to what extent. In this step, the analyst must build scenarios into the
Sensitivity Analysis model to perform sensitivity analysis. In other words, the resilience of the business
model will be tested based on scenarios. This step is beneficial as it helps assess
variation in performance in case of an unanticipated event.

Here the analyst assumes the worst-case (extreme) scenario based on some unfortunate event during
#7 – Stress Testing of the a specific period, say a decade. For instance, the recession of 2008-09 is used for stress testing the
Forecast forecasting models of US-based companies. This step is also crucial as it helps understand how a
6 company will behave in such an extreme scenario and whether it can sustain itself.
 The three-statement
model is the most basic
setup for financial
modeling. As the name
implies, the three
THE THREE-STATEMENT MODEL statements (income
statement, balance sheet,
and cash flow) are all
dynamically linked with
formulas in Excel

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DISCOUNTED CASH FLOW

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 Year Cash Flow
FIND THE DCF BY YEAR, GIVEN 0 150000
THE DISCOUNT RATE IS 8% 1 225000
2 247500
3 272250
4 299475
9 5 329423
Year Cash Flow Present Value Discounted Discounted Cash Flow
Factor 8% by year

0 150000 0

1 225000 0.9259

2 247500 0.8573

3 272250 0.7938

4 299475 0.7350

5 329423 0.6806
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 NPV = DFC-INITIAL INVESTMENT

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 ArcelorMittal, JSW in
NMDC steel plant
race; JSPL also in the
CASE STUDY fray

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 Sum Of The Parts (SOTP)
valuation is an approach to
valuing a firm by separately
assessing the value of each
business segment or subsidiary
and adding them up to get the
SUM OF THE PARTS (SOTP) total value of the firm. It can
be used in conjunction with
various valuation techniques
VALUATION such as Discounted Cash Flow
(DCF) modeling and
comparable company analysis.

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