A standard financial model is a spreadsheet-based tool used to forecast a company’s financial performance. It’s an abstract, numerical representation of a business that helps analysts, investors, and managers make informed decisions.
The most common and foundational type is the three-statement model, which integrates the income statement, balance sheet, and cash flow statement.
The Three-Statement Model
This model is the backbone of most financial analysis because it captures the fundamental financial health of a company. By linking the three core statements, it shows how changes in one area of the business affect the others, creating a complete picture of profitability, liquidity, and solvency.
- Income Statement: This statement shows a company’s revenues, expenses, and profitability over a specific period (e.g., a quarter or year). It starts with revenue, subtracts various costs, and arrives at the net income.
- Balance Sheet: This is a snapshot of a company’s assets, liabilities, and shareholders’ equity at a single point in time. It must always “balance,” meaning the total assets must equal the sum of total liabilities and equity.
- Cash Flow Statement: This statement tracks how cash is generated and used by a company through its operating, investing, and financing activities. It’s crucial because it shows the actual movement of cash, which can differ significantly from net income due to non-cash expenses like depreciation.
How to Build a Standard Financial Model?
Building a robust three-statement model involves a logical, step-by-step process.
- Gather Historical Data: Start with at least 3-5 years of a company’s historical financial statements. This data forms the foundation for your assumptions and projections.
- Make Assumptions: This is the most crucial step. Based on historical trends, market research, and business strategy, make educated assumptions for key drivers like revenue growth, cost of goods sold (COGS), operating expenses, and capital expenditures.
- Build the Income Statement: Using your assumptions, project the company’s revenue and expenses to calculate future net income. This is typically the first statement you build.
- Construct the Balance Sheet: Forecast the balance sheet items, linking them to the income statement and cash flow statement. For example, accounts receivable are often linked to revenue, while property, plant, and equipment (PP&E) are linked to capital expenditures and depreciation.
- Develop the Cash Flow Statement: This statement is largely built using information from the other two. It begins with the net income from the income statement, adjusts for non-cash items, and incorporates changes in working capital and other balance sheet items.
- Integrate and Validate: Ensure the model is integrated, meaning all the statements are linked correctly. Check that the balance sheet balances and perform sanity checks and sensitivity analysis to test how the model’s outputs change when you vary a key assumption.
Common Uses of Financial Models
Financial models serve a variety of purposes across different industries.
- Valuation: Models like the Discounted Cash Flow (DCF) model use the three-statement model’s cash flow projections to estimate a company’s intrinsic value.
- Mergers & Acquisitions (M&A): Merger models analyze the pro forma financial impact of a potential merger or acquisition, helping determine if a deal is accretive (increases earnings per share) or dilutive (decreases earnings per share).
- Leveraged Buyouts (LBOs): LBO models analyze the viability of acquiring a company using a significant amount of debt, focusing on the company’s ability to service that debt and generate a return for investors.
- Budgeting and Forecasting: Companies use financial models to create annual budgets, forecast future performance, and allocate resources.