Financial modeling is a tool to analyze a particular company’s historical performance and relevant market data on comparable companies operating in the same (or adjacent) industry to project its financial performance.
By forecasting the operating and financial performance of a company (or project), financial models are practical for various use-cases and guide decision-making, such as in the context of performing a valuation or capital budgeting analysis.
What are the Financial Modeling Best Practices?
Financial modeling best practices refer to industry-standard modeling conventions and tips to adhere to when building models in Excel.
Following these general guidelines and industry best practices ensures that the financial models built on the job are intuitive, error-proof, and structurally sound.
Like many computer programmers, people who build financial models can get opinionated about the “right way” to do it.
In fact, there is surprisingly little consistency across Wall Street around the structure of financial models.
One reason is that financial models can vary widely in purpose, which, along with the context of the analysis, determines the required level of granularity and structure of the model.
For example, if your task was to build a discounted cash flow (DCF) model to be used in a preliminary pitch book as a valuation for one of 5 potential acquisition targets, it would likely be a waste of time to build a highly complex and feature-rich model.
The time required to build a super complex DCF model isn’t justified, given the purpose of the financial model (and the context of the analysis).
On the other hand, a leveraged finance model used to make thousands of loan approval decisions for various loan types under various scenarios requires a lot of complexity.
What are the Different Types of Financial Models?
The most common types of financial models include the following:
| Type of Financial Model | Description |
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| 3-Statement Model | - The 3-statement model projects the operating and financial performance of a particular company using historical data, relevant industry data, and management guidance, among others.
- The forecasted financial statements include the income statement, balance sheet (and supporting B/S schedules), and cash flow statement.
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| Discounted Cash Flow (DCF) Model | - The DCF model is a method to estimate the intrinsic value of a company by projecting the free cash flow (FCF) generation of a company and discounting the FCFs to the present date using an appropriate discount rate.
- In a two-stage, unlevered DCF analysis, the sum of the stage 1 cash flows (i.e. explicit forecast period) and the terminal value (TV) is the implied enterprise value (TEV) of the company.
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| Merger Model (Accretion/Dilution Analysis) | - A merger model, or accretion/dilution analysis, is a model built to analyze the pro forma impact on the earnings per share (EPS) of an acquirer post-M&A.
- In short, the purpose of a merger model is to determine whether a merger or acquisition is accretive or dilutive to EPS.
- If the pro forma EPS of the combined entity exceeds the pre-transaction EPS, the deal is “accretive” – in contrast, the transaction is deemed “dilutive” if the pro forma EPS is less than the pre-transaction EPS.
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| Leveraged Buyout (LBO) Model | - An LBO model is used by private equity firms that engage in leveraged buyouts (LBOs), which are acquisitions of companies where a substantial percentage of the purchase price is funded by debt.
- The LBO model determines the “floor valuation” of a potential investment, i.e. the maximum purchase price at which the PE firm can offer to acquire the target yet still meet its minimum return hurdle.
- The output of an LBO analysis offers insights regarding the implied internal rate of return (IRR) and multiple on invested capital (MOIC)
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| Comparable Company Analysis (Trading Comps) | - The trading comps model is a form of relative valuation, where the value of the target company is estimated by analyzing the valuation multiples of comparable companies (i.e. industry peers), which are most often competitors.
- The process of conducting a trading comps analysis requires gathering the current valuation multiples of comparable companies and applying the mean or median to the target company’s metric.
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| Precedent Transactions Model (Transaction Comps) | - The transaction comps model, similar to the trading comps model, is categorized as a method of relative valuation.
- But rather than pricing a company based on the current trading multiples of comparable companies, the method estimates the value of a company based on the purchase prices paid by investors in recent M&A transactions.
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| Restructuring Model | - The core restructuring model values a distressed company in a two-fold process (Chapter 11 Reorganization vs. Liquidation Valuation Method).
- The restructuring model estimates the value of a company on a “going concern” basis (post-reorganization) and then compares the valuation to the implied value of the liquidated assets belonging to the company.
- The 13-week cash flow model (or TWCF) is a model prepared under cash-based accounting instead of accrual accounting to measure the near-term performance of a distressed company to quantify its short-term liquidity needs.
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| Capital Investment Model | - A capital investment model is used as part of a capital budgeting analysis, where metrics such as the net present value (NPV), internal rate of return (IRR), and payback period are computed to decide whether to proceed with a project or not.
- Capital investment models are most often used internally by corporations to determine if a project is worth pursuing from an economic perspective and to guide their long-term strategic plans to achieve growth and scale.
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| Lender Credit Model | - Credit models are used by lenders to perform credit risk analysis on a specific borrower and request for debt capital.
- The credit model will estimate the debt capacity of the borrower, gauge the risk of default, and determine the appropriate amount of debt to offer (i.e. debt sizing) based on the borrower’s risk profile.
- The implied credit risk derived from the credit model is used not only to size the debt financing but also to set the terms appropriately, namely the interest rate, based on the risk undertaken by the lender.
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