Who Uses Financial Models? Overview Of Industries That Require Them

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February 25, 2023 Lekshmi S S Financial Modeling, Knowledge

Wondering what to do after completing a financial modeling course? Or are you wondering whether this is something people use? Or just curious about the different fields that use financial models as decision-making tools? Unsure which industry to apply to? Are you curious as to who uses financial models? If so, then look no further and read on to find the answer to all these questions.

A Quick Recap: What is Financial Modeling?

The process of making a model that is telling of the financial representation of a company is called financial modeling. And from these financial models, predictions can also be made about the future number of sales and probable losses to a highly accurate level. Using these models and the various budget and forecast theories involved in them, an analyst can make profitable changes to business plans and promote the more profitable product predicted, more. Once the model is completed, it is represented as numerical values of the business events, hence, the excel spreadsheet is majorly used as the main tool to make these financial models.

Why Are These Financial Models Used?

These models are mainly used as decision-making tools, as they can predict the future with high accuracy. The models are used to compare similar peer products or groups or company statistics, test different scenarios with different parameters to see which yields the best result, and make decisions and changes, if required, to a business plan for maximum profit. Some of the decisions that are made can include:

Deciding whether to increase company capital
Deciding on the budget for each product or project
Valuing the business
Deciding whether to sell or buy an asset or business unit.
Giving importance to the most profitable project predicted over the others.
Distribution of financial resources accordingly
Estimating the business growth
Risk management analysis

How Are Financial Models Created – a Quick Overview

The creation of financial models is a repetitive process of following certain steps over and over again. Financial modelers who create the models, work on different sections first and then bring it all together with the help of the model. A short overview of these steps is given below:

Bringing past year’s results and assumptions
Starting the balance sheet
Starting the income statement
Completing the balance sheets and income statement
Building the support schedules
Building the cash flow statement
Performing the Discounted Cash Flow (DCF) analysis
Adding and testing various scenarios and performing sensitivity analysis on them
Building charts and graphs
Stress test and auditing the model

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Which Industries Use Financial Models?

In the previous article, we discussed the top institutes offering financial modeling courses in India, and in this article, let’s see where and who uses these models for the benefit of their business. Financial modeling is mainly used in the following industries:

Investment Banks:

Investment banks are part of banks that prioritize organizing large and complex financial transactions like initial public offering (IPO) underwriting or having mergers or involving other deals like leveraged buyouts, and corporate restructuring, and an investment banker is a person who utilizes these models to help raise the company’s capital. If you’re looking to work in this sector of banking, then the creation and knowledge of financial modeling is a must.

Financial models are mainly used during decision-making time. And depending on the type of transactions involved, these models can be very different from each other. For investment banking, the models are mainly built to value companies accurately, since the type of transactions involved mainly out of everything else is merger & acquisition, and capital rises.

Other than the future prediction values, these models are also used to know the final price at which the company shares need to be given a detailed valuation. A financial model is used to figure out major revenue and cost drivers that impact the valuation. The revenue estimation can be carried out in different segments in case the company has different or multiple sectors, and thereby, there will be different revenue drivers. But even with all these different segments, a financial model can easily do a revenue estimation. It can also allow the addition and regrouping of data if required. Once the cash flows are generated, the discounted cash flow method is applied to arrive at the final value.

If the valuation is based on the values of a similar peer group, then this valuation is called relative valuation. In this case, the first step is to select an appropriate peer group, analyze various operating parameters involved, and collect all necessary information. The model helps in a quick comparison of the selected parameters and identifies the right peer group. Once this is completed, the valuation numbers of the peer group are derived. Now, the valuation for the initial public offering is calculated based on all available estimates in the model and the peer group valuation multiples. This entire process is usually done when companies are offering their shares to the public.

Another case is that of a leveraged buy-out. In this case, an asset is bought on credit. After the pledge, the cash flows from the asset to the company. The cash flows of the asset will be used to repay the loan amount and interest to the financier. In this case, an investment banker needs to do a detailed study to analyze the cash revenue and figure out the cash flow that can be generated from the asset. Here, a model that can forecast the revenue and costs involved with the operations of the asset is created. The same model can be used for different scenario analysis, risk analysis and management involved in the leveraged buyout deal.

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The banker can represent the buyer or the seller, but regardless, the investment banker is the one who does the valuation of the target. A model will be created with all the necessary information, which can also be used in the negotiation discussions between the buyer and the seller. A good model, able to restructure the parameters and still show accurate valuation is necessary here.

Credit Rating Agencies:

An agency that does credit analysis, which, in simple terms, is a process to calculate the creditworthiness of a business or company. In other words, it is a type of financial analysis performed on companies or any other debt-issuing entities to measure the borrower’s ability to meet its obligations. Hence credit analysis is used mainly in 2 cases – when a company its bonds in the market, and when a business takes a loan from banks or any other sources. The credit analysis in these cases is used to determine 3 main things –

Risk analysis
Assessing the default probability by the borrowing party
Calculating the loss percentage that the lender can suffer in the event of default

Various credit analysis techniques are used to arrive at the desired outcome like credit history and repayment ability analysis (where any history of occurrence of default of negotiations is thoroughly checked), detailed analysis of cash flow (which checks whether the company will have any liquidity issues or if it can generate adequate cash to address the needs), collateral analysis (the main element in risk analysis, that if in case of an unfortunate incident, collateral needs to be sold to recover the amount to be repaid), ratio and trend analysis (here the initial projection of basic financial ratios like inventory days, accounts payable days, accounts receivables days, etc. are used as different scenarios for analysis), financial statement analysis (banks or the lenders would normally ask for the business’s financial statements, working capital, debtors, creditors, reserves, other loan details, etc.). Among these is the credit scoring system. This is a quantitative, accounting-based system in which the credit analyst will compare different key accounting ratios of borrowers with the industry or company norms and other major trends in their variables. Here, financial models will provide the exact inputs to the credit scoring system.

Another use for these models arises while making projections. Accurate predictions are very important for any credit decision. But these can also be very challenging to make. Here, a financial model based on previous and future estimates becomes extremely handy. In such a model, the main focus will be to evaluate the cash flows that are expected to be generated in the future and determine if that will be sufficient enough to cover the interest and principal payments during this period. After reviewing the report, the bank can decide whether to lend the money or not.

Hence, Credit analysis requires the use of financial models based on a good foundation of financial statements and expert modeling skills, and an expert in financial modeling checks both these boxes.

Equity Research:

The study of a business and its valuations to decide on whether to sell or buy its shares. This means analyzing the company’s finances, performing ratio analysis, forecasting these financials, and exploring the scenarios of both buying and selling. The analyst can use the model to explain a certain outcome due to a certain input in a scenario and suggest a change in the business strategy. Here also the main parameters are the company’s stock values, past and present financial statements including income statements to predict future valuations. These can ultimately help in deciding on buying or selling the company stocks and shares.

One of the main models in equity is the leveraged buyout model (LBO model). In these models, the task is to calculate the annual rate of return you can earn by investing in a business, how long it is good to hold your stake, and finally selling it. This model is mainly used because equity firms usually use a combination of Debt and Equity to fund acquisitions of big companies/ businesses. Here the need to track debt repayment and associated items makes even the Excel formulas more complex. But if it is an equity firm that does not use debt, only focusing on equity, then the model and formulas can be simple. In this kind of growth equity model, only cash flow projections, purchase price, and exit values.

Regardless of the difference in the model, the end goal is the same for both – determine ranges for the multiple of invested annual returns and the invested capitals.

Education Industry:

One of the biggest changes brought about by the COVID pandemic is shifting offline classroom education to online classes. A remote education. Even after the major waves of the pandemic, several institutes are looking for a long-term online initiative. A successful long-term online institute will be dependent on not just the course content and good quality trainers, but also on the financial strategy and use of these strategies to decide an overall budget and year-long plan. Financial models come into play here. These models, with the right input, can provide an accurate valuation of all aspects needed to run an online institute. While the specific input will vary with the institute and program, the basics are pretty much the same – lifespan of a program, number of courses offered, number of trainers allotted to each course, trainer’s salaries, tuition fee of each course, the charge of marketing and licensing, and online project management (OPM) vendor fees. Changes can be made to the parameters in the model, but this will yield a simplified overview of all revenue and expenses involved for an online training institute.

Even if it’s not an online institute, just starting a normal offline educational institute, only the parameters added to the model would change. The additional infrastructural costs and the cost of its maintenance will be some of the main things to add. But basically, the role of the model will be the same, to help the school/ institute business financial management. Some other key factors in this case are:

Creating a 3–5-year budget plan focused on school development
Selection of efficient staff
Financial planning based on delivering good educational results
Using existing financial systems that promote constructive challenges
The main leaders of the institute have financial skills to help manage school finances.

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Project Management:

A Project Manager is required to have a plethora of skills – from being a good leader, knowing how to read body language, negotiate, and also being able to build, review and analyze project finance models at every level. No matter what industry, be it healthcare, education, information technology, business, marketing, manufacturing, e-commerce, energy, or geology – all these industries need people with project management talent. Project managers are people responsible for taking up initiatives and projects that can boost market competitiveness as well as positively impact the respective company’s business plans and goals. Trained in financial modeling, project managers can not only understand the business better with all its numbers but also deliver the knowledge correctly such that the organization, its employees, and clients will be greatly rewarded.

The project financial model is created at the beginning of the project assessment stage, and it is continuously expanded and information is added on, updated, removed, analyzed, and evaluated. Since these are continuously evolving models, they should be flexible but not too complex and should be easy to be understood for the client to make better-informed decisions. The financial evaluations of a project are dependent on the expected future cash flows generated by every activity of a completed project.

The main calculations will be done on revenue, accounting and tax, debt financing (if required), project internal rate of return, and distributions to equity. Other parameters will vary with the industry or project in question. The main expected output should contain a summary of the project metrics relevant to make informed decisions, and it should include financial statements – the income statements, balance sheets, and cash flow statements.

After the initial model is built, various scenario analysis is conducted based on variations done to the model inputs and assumptions. These scenarios can include a base case, an upside case, and a downside case; the variations can be a fixed amount or can change in inputs; the scenarios are usually compared side by side. Based on these changes in inputs and assumptions, the impact of key outputs is also compared side by side. Relevant model outputs will depend on the model user and what they’re looking for but some of the most important financial model outputs are:

The Debt Service Coverage Ratio (DSCR) – This is the main output value that is used to determine the likelihood of a loan being repaid.
Internal Rate of Return (IRR) – This is the main output value used by equity investors to determine the level of returns to be expected from their investment.
Net Present Value (NPV) – This is the main output value that shows the difference between the present value of the future cash flows from an investment and the amount of investment.

Healthcare Industry:

Health is one of the fundamental necessities of life. For all riches of the world, if you’re not alive and healthy to enjoy it, is there a point in that? Hence why selecting the most appropriate model of the health care system is essential for any country. This includes the use of material resources, quality improvement, and better accessibility of health care to everyone. To involve everything, a proper budget is required, and even more importantly, a good financial model is required, that will have all the necessary points covered to give the best potential result. In this modern era, most healthcare financing models are divided into 3 – budget state, social insurance, private or market.

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The first model, known as the Semashko-Beveridge budget model, takes its main source of finance from tax revenues and free medical care.

The second model, known as the Bismarck model, is based on the principles of a mixed and sophisticated economy that integrates health care with advanced government regulations and socially guaranteed benefits. This model is often regarded as a regulated health insurance system.

The third model is private. Here the health care services are provided based on private insurance and payments from citizens’ funds.

All financial models in healthcare involve the cost of types of equipment, hospital infrastructure, necessary items for the ward, medicines, social insurance, Govt. grants, etc.

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Frequently Asked Questions (FAQs)

Q1. Why are financial models necessary?

Financial models are necessary for any field to determine the cost of capital, allow for well-informed decisions to be made for a company’s growth, give a detailed review of the debt/ equity system, how to profitably invest in a business or sell a business share with maximum profit, etc.

Q2. Who can make financial models?

Anyone with financial modeling knowledge can create these models, but typically they are:

Financial analyst
Financial manager
Business analyst
Market research analyst
Equity analyst
Associate analyst

Q3. What are some other areas where financial models are used?

DCF modeling
Venture capital
IP Valuation – option-based method
IP Valuation – market-based method
Asset allocation
Qualitative analysis
Revenue driver
Mutual funds
Financial KPOs

Conclusion

At the first glance, financial modeling may not seem like a big thing, especially if you’re new to this. But it is a subject used in almost every field and every industry. With the growing business world, the need for financial modeling will only continue to increase. Hence why it is a great career option for anyone. This article provides details on some of the main industries using financial modeling but there are many more. Hopefully, the article provides enough insight for anyone wanting to take up the course.

Who Uses Financial Models? Overview Of Industries That Require Them