When developing, evaluating, and understanding financial models for strategic planning and decision-making, specific vocabulary and fundamental ideas are referred to as financial modeling terms.
What's a Financial Model?
A financial model is like a maths picture of a company's past, now, and what might happen in the future. It's a tool to help make smart choices. Imagine a boss using it to figure out how much money a new idea might make or cost.
People called financial analysts also use these models. They help guess how things, both inside and outside a company, could affect its money situation. Like if a company changes its plan or if the government makes new rules, it can change how much money a company makes.
These models don't just predict money stuff. They also help figure out how valuable a business is or compare one business to others in the same group. They're handy for planning too. Companies use them to test different ideas, figure out project costs, set budgets, and decide where to put their resources.
So, financial modelling is the process of making these helpful money models. Before diving into that, let's check out some important terms related to financial modelling.
Financial Modeling Terms
NPV (Net Present Value):
- Explanation: Net Present Value (NPV) is a financial metric used to evaluate the profitability of an investment by comparing the present value of its expected cash inflows with the initial investment cost. It helps assess whether an investment is likely to generate positive returns.
- Example: Imagine a company is considering a new project that requires an initial investment of $50,000. Over the next five years, the project is expected to generate cash inflows of $20,000 per year. To calculate NPV, future cash inflows are discounted to their present value (considering the time value of money). If the NPV is positive, it suggests that the investment is likely to be profitable.
- Significance: A positive NPV indicates that the investment is expected to yield returns higher than the cost of capital, making it potentially worthwhile. Conversely, a negative NPV suggests that the project may not generate sufficient returns to cover its costs.
- Formula: The NPV formula involves subtracting the initial investment cost from the present value of expected cash inflows.
Excel Formulas for NPV:
=NPV(rate, value1, [value2], …)
Mathematically, it is expressed as:
- Decision Making: When comparing different investment opportunities, a higher NPV suggests a more attractive investment. It helps businesses make informed decisions by considering the time value of money and future cash flow expectations.
In summary, NPV is a valuable tool in financial modeling, aiding businesses in assessing the profitability of potential projects or investments by considering the timing and value of future cash flows.
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization):
- Explanation: EBITDA is like a financial tool that helps us see how well a company is doing in its main business activities. It looks at how much money the company makes before considering some complicated expenses like interest on loans, taxes, and the wear and tear of stuff they own.
- Example: If a lemonade stand makes $1,000 selling lemonade and spends $300 on things like lemons and cups, the EBITDA would be $700 ($1,000 - $300).
Mathematically, it is expressed as:
- Significance: EBITDA helps us understand how good a company is at making money from its main operations without getting tangled up in extra financial stuff.
- What's Left Out: It doesn't consider loan interest, taxes, asset aging, or loan repayments.
- Usage: People use EBITDA to compare how well different companies are doing at their core businesses, especially in industries where things like buying new equipment or dealing with loan payments are important.
- Limitations: While EBITDA is handy, it doesn't tell the whole story. It misses some important details like changes in the money a company has on hand, spending on new stuff, and paying off debts. So, it's often used alongside other numbers for a better understanding.
In a nutshell, EBITDA helps us see how much money a company is making from its main activities without being bothered by some of the more complex money matters.
IRR (Internal Rate of Return):
- Explanation: Internal Rate of Return (IRR) is a financial metric used to assess the potential profitability of an investment. It represents the discount rate at which the net present value (NPV) of the investment becomes zero. In simpler terms, IRR helps determine the rate of return at which an investment breaks even.
- Example: Suppose a company is considering a project with an initial investment of $100,000. The project is expected to generate cash inflows of $30,000 per year for the next five years. The IRR is the discount rate at which the present value of these cash inflows equals the initial investment. If the IRR exceeds the company's cost of capital, the investment is considered viable.
- Significance: A higher IRR indicates a more attractive investment opportunity. It is a valuable tool for decision-making because it considers the time value of money and provides insight into the potential return on investment.
- Formula: The IRR is the discount rate that makes the NPV of the investment zero.
Excel Formulas for IRR:
=IRR(values, [guess])
Mathematically, it is expressed as the rate (r) in the formula:
- Decision Making: When comparing different investment opportunities, a higher IRR suggests a more favorable investment. Businesses often use IRR alongside NPV to make well-informed decisions about potential projects or investments.
In essence, IRR provides a percentage that reflects the rate of return an investment is expected to generate, allowing businesses to evaluate the attractiveness of various investment opportunities.
Top 10 Types of Financial Models
Here are the primary ten financial models commonly employed in corporate finance by financial modeling professionals:
- Three-Statement Model: Shows a company's financial picture using three main statements: income, balance sheet, and cash flow.
- Discounted Cash Flow (DCF) Model: Calculates the present value of future cash flows to assess the worth of an investment.
- Merger Model (M&A): Used when companies consider joining forces or merging.
- Initial Public Offering (IPO) Model: Helps companies plan and evaluate their finances when going public and selling shares on the stock market for the first time.
- Leveraged Buyout (LBO) Model: Used when a company is bought with a significant amount of borrowed money.
- Sum of the Parts Model: Values a company by adding up the individual values of its different parts or divisions.
- Consolidation Model: Combines financials of multiple entities to show their overall performance.
- Budget Model: Helps plan and manage a company's spending and income for a specific period.
- Forecasting Model: Predicts future financial outcomes based on current data and trends.
- Option Pricing Model: Calculates the value of financial options, like the right to buy or sell assets at a future date.
Which Careers Use Financial Modeling?
- Investment Banking : Investment bankers assist companies in raising capital and executing transactions such as mergers and acquisition (M&A).
- Private Equity : Private equity firms raise capital from outside investors then use this capital to buy, operate and improve companies before selling them at a profit.
- Venture Capital : Venture capital firms raise capital that is invested in early-stage, high-growth companies with a view to exiting via acquisition or IPO.
- Hedge Funds : Hedge fund managers raise capital from institutional investors and accredited investors and invest it in financial assets.
- Corporate Banking : Corporate bankers aim to win and retain clients who hire the bank for M&A deals, debt and equity issuances, and other transactions with higher fees.
- Corporate Development : Corporate Development focuses on acquisitions, divestitures, joint venture (JV) deals, and partnerships internally at a company.
- Equity Research Analyst : Equity research relates to the sell-side role at investment banks where you make Buy, Sell, and Hold recommendations on public stocks.
Freequently Asked Questios:
1. What Is Financial Modeling Used For?
A financial model helps people make smart decisions and analyze money-related stuff in and out of companies. Companies use it for things like getting money, growing, selling parts of the business, deciding where to put money, planning budgets, predicting the future, and figuring out how much a business is worth.
2. What Types of Businesses Use Financial Modeling?
Lots of different professionals use financial modeling for different jobs. For example, bankers use it for sales, trading, and various banking tasks. Public accountants use it to check and value things. And in places like private equity and portfolio management, financial models help with investments and research.
3. What details need to be part of a financial model?
To make a good and easy-to-understand model, include parts about assumptions, income, balance, cash flow, schedules, valuations, sensitivity, and use charts and graphs.
Conclusion:
Financial modeling is like a tool companies use to figure out how well they're doing and make smart choices. To use it well, you need to know the terms related to financial modeling. These terms help you understand the model and use it effectively. In simple words, they stop you from getting confused and make it easier to ask for help.
One common type of financial modeling is the three-statement model. It uses three main reports: balance sheet, income statement, and cash flow statement. The words used in these reports help investors and managers grasp how the company works. So, knowing these terms is crucial for understanding and making the most of financial models.
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