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What is a Financial Model

By Gerard Kelly |

 Reviewed By Rebecca Baldridge |

April 7, 2022

What is a Financial Model?

A financial model is created to forecast an organization’s financial performance over time. Models are typically built-in Excel, with historical data used to help forecast how the organization will perform in the future. Financial models play an important role in helping firms make important decisions, such as whether to invest in a project.

Key Learning Points

  • Financial models are used to forecast a company’s future financial performance and then use the forecast for a variety of purposes, including company valuation , project appraisal, acquisition decisions, debt issuance, credit ratings, and more.
  • Financial models are used by bankers, accountants, consultants, economists, portfolio managers, quantitative analysts, and financial planners, as well as anyone who will benefit from forecasting the future financial performance of an organization.
  • It’s essential to have a strong understanding of accounting to build a financial model. Modeling is typically learned through specialized courses or in-house training at financial services companies.

What is a Financial Model Used For?

A model is a basis for any decision that involves forecasting the future of a company.

For example, an M&A (mergers and acquisitions) analyst would build a model to determine whether merging two companies would yield financial performance that exceeds the results generated by each company independently.

A credit rating model will forecast future results to determine whether a company will be able to maintain certain financial ratios and meet its debt obligations, thus maintaining its credit rating. A valuation model forecasts the future cash flows of a company and then asks how much we would pay now for those future cash flows. This is called Discounted Cash Flow analysis, which yields a figure called Net Present Value.

An operational model will focus on forecasting a company’s revenue and costs, and then alter the model’s assumptions to determine whether performance can be improved through measures such as cost-cutting.

What Does a Financial Model Typically Include?

Financial models typically include pro forma versions of a company’s balance sheet , income statement , and cash flow statement . However, the emphasis on each particular financial statement may vary according to how the model will be used.  Management consultants, for example, might focus more on revenue improvement and therefore focus their attention on the factors that drive revenue.

Who Builds Financial Models?

Professionals in many different areas of the financial services industry depend on financial modeling in their decision-making processes.

Investment bankers include professionals working in M&A, equity and debt underwriting, credit, and trading. A  financial forecast is an important component underlying every banking transaction.

Investment managers such as mutual fund and hedge fund managers, private equity investors, and venture capitalists all use financial models as the basis for investment decisions.

Management consultants offer advice and expertise to help organizations improve business performance in terms of operations, profitability, management, structure, and strategy. A financial model provides a base case for the company, and consultants can alter assumptions to determine the optimal course of action.

Equity analysts rate stocks on a buy, sell, or hold basis that is determined through valuation models. Through various methods, including discounted cash flow analysis, analysts determine the fair value of a stock and compare it to the stock’s market value to recommend a course of action.   When a company discusses financial results, issues a trading update, or provides management guidance, analysts adjust their financial models and offer an investment recommendation

How Can You Learn Financial Modeling?

Textbooks on topics such as corporate finance or business valuation may provide an introduction to financial modeling. Articles or blogs (such as those found on this website) can offer useful insights on financial modeling. Please go to the Finance Library section of our website to learn more. Terms you should understand include:

  • three statement model
  • assumptions
  • income statement and income statement forecasting
  • operating profit and EBIT
  • balance sheet and balance sheet forecasting
  • cash flow statement
  • linking three financial statements
  • 10 steps in building a three statement model
  • M&A or merger model
  • DCF or discounted cash flow

The best way to learn to model is to complete our online financial modeling course that gives you an introduction to building models and developing multiple techniques for a comprehensive and practical understanding of the topic.

The Basics of Financial Modeling

Read our article titled “ How to Build a Financial Model ” which takes you through the basic steps.

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Financial Model 2

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What are the different financial models?

An insight into financial modelling, its meaning, objective, types, categories and ten points to follow while creating financial models.

  • Finance Process

Financial modelling is interpreting numbers of features of a company’s operations. Financial modelling is the task of building an abstract representation, called financial models, of a real-world financial situation. It is a mathematical model constructed to denote a simplified version of the performance of a financial asset or portfolio of a business, project, or any other investment.

Financial models are activities that prepare a model representing a real-world financial situation. they are intended to be used as decision-making tools. Company executives might use financial models to estimate the costs and project the profits of a proposed new project. Financial analysts use financial models to anticipate the impact of an economic policy change or any other event on a company’s stock.

Common types of financial models are Initial Public Offering (IPO) Model and Leveraged Buyout (LBO) Model.

Financial modelling: meaning

Financial modelling is the method performed to build a financial representation of a company. Financial analyst forecast future earnings and performance of the company using these financial models. The analysts use numerous forecast theories and valuations provided by financial modelling through these financial models to recreate business operations. Financial models once completed, display a mathematical depiction of the business events. The primary tool utilized to create the financial model is the excel spreadsheet.

Investopedia definition of Financial modelling: The process by which a firm constructs a financial representation of some, or all, aspects of the firm or given security. The model is usually characterised by performing calculations and makes recommendations based on that information. The model may also summarize particular events for the end user and provide direction regarding possible actions or alternatives

Financial modelling: objectives

Financial models help in steering historical analysis of a company, projecting a company’s financial performance used in various fields.

These financial models are predominantly used by financial analysts and are constructed for many purposes. Financial modelling supports the management in the decision-making and the preparation of financial analysis by creating financial models.

The following are the objectives of creating financial models:

  • Valuing a business
  • Raising capital
  • Growing the business
  • Making acquisitions
  • Selling or divesting assets and business units
  • Capital allocation
  • Budgeting and forecasting

The best financial models offer a set of basic assumptions. For example, one commonly forecasted line item is sales growth. Sales growth is documented as the increase, or decrease, in gross in the most recent quarter compared to the previous quarter. For financial modelling, these are the only two inputs financial models need to calculate sales growth.

Financial modelling will create one cell for the prior year’s sales, cell A, and one cell for the current year’s sales, cell B. The third cell, cell C, would be used for a formula that divides the difference between cell A and B by cell A. This will be the growth formula. Cell C, the formula, would be embedded into the model. Cells A and B are input cells that can be changed by the user.

In this case, the purpose of financial modelling and creating financial models is to estimate sales growth if a certain action is taken or a possible event occurs.

Financial modelling: ten points to follow

Financial modelling is an iterative process. Analysts creating financial models must chip away at different sections until they are finally able to tie it all together.

Below is a step-by-step breakdown of where they should start and how to finally connect all the dots.

  • Historical results and assumptions
  • Start the income statement
  • Start the balance sheet
  • Build the supporting schedules
  • Complete the income statement and balance sheet
  • Build the cash flow statement
  • Perform the Discounted Cash Flow (DCF) analysis
  • Add sensitivity analysis and scenarios
  • Build charts and graphs
  • Stress test and audit the model

Financial modelling: categories

There are multiple varieties of financial modelling tools that are exercised, based on the purpose and need of doing it. Each category of the financial models solve a different business problem. While the majority of the financial models concentrate on valuation, some are created to calculate and predict risk, performance of portfolio, or economic trends within an industry or a region.

The key to being able to model finance effectively is to have good templates and a solid understanding of corporate finance.

Examples of financial models available include:

Project finance models

When a sizable infrastructure project is being evaluated for feasibility, the project finance model helps determine the capital and structure of the project. Project finance is only possible when the project is capable of producing enough cash to cover all operating and debt-servicing expenses over the whole tenor of the debt.

Loans and the associated debt repayments are an imperative part of project finance models, since these projects are normally long term, and lenders need to be sure if the project can bring sufficient cash against the debt. In other words, project finance model is used as a financial model when the company needs to assess economic feasibility of the project.

Metrics such as debt service cover ratio (DSCR) are included in this category of financial modelling and can be a handy yardstick of the project risk, which may affect the interest rate offered by the lender.

Right at the start of the project, the DSCR and other metrics are agreed upon between the lender and borrower such that the ratio must not go below a certain number.

While the output for a project finance model through financial modelling is uniform and the calculation algorithm is predetermined by accounting rules, the input is highly project specific. Generally, it can be subdivided into the following categories:

  • Variables needed for forecasting revenues
  • Variables needed for forecasting expenses
  • Capital expenditures

Pricing models

This category of financial models is built for the idea of establishing the price that can or should be charged for a product.

Price is one of the key variables in the marketing mix. There are four general pricing approaches that companies use to set an appropriate price for their products and services: cost-based pricing, value-based pricing, value pricing and competition-based pricing. The cost of production sets the lower limit while the upper limit is set by consumer perception about the product/service.

The input to a pricing model is the price, and the output is the profitability. To create a pricing model through financial modelling, an income statement, or profit-and-loss statement of the business or product should be created first, based on the current price or a price that has been input as a placeholder. At a very high level:

Units × Price = Revenue

Revenue – Expenses = Profit

However, this category of financial models can be very complex and involve many different tabs and calculations, or it can be quite simple, on a single page. When this structure model is in place, the person doing the financial modelling can perform sensitivity analysis on the price entered using a goal seek or a data table.

Integrated financial statement models

This category of financial models is also known as a three-way financial model.

The three kinds of financial statements included in the financial modelling of an integrated financial statement model are the following:

  • Income statement, also known as a profit-and-loss (P&L) statement
  • Cash flow statement
  • Balance sheet

Not every category of financial model needs to contain all three types of financial statements, but many of them do, and those that do are known as integrated financial statement models.

From a financial modelling outlook, it’s very important that when the financial modelling for an integrated financial statement takes place, the financial statements are linked together properly so that if one statement changes, the others change as well.

Valuation models : This category of financial models value assets or businesses for the purpose of joint ventures, refinancing, contract bids, acquisitions, or other kinds of transactions or deals.

The people who build these kinds of models are often known as deals modelers.

Building this kind of financial models requires a specialized knowledge of valuation theory and using the different techniques of valuing an asset, as well as financial modelling skills .

When valuing a company as a going concern there are three main valuation methods used by industry practitioners:

  • DCF analysis
  • Comparable company analysis
  • Precedent transactions

These are the most common methods of valuation used in investment banking , equity research, private equity, corporate development, mergers & acquisitions (M&A) and most areas of finance. A common example of these category of financial models is Initial Public Offering (IPO) Model and Leveraged Buyout (LBO) Model.

Reporting models

These financial models condense the history of revenue, expenses, or financial statements, like the income statement, cash flow statement, or balance sheet.

Because they look historically at what occurred in the past, there is school of thought that these financial models are not real financial models. The fundamentals like principles, layout, and design that are used in financial modelling are identical to other financial models.

Reporting models are often used to create actual versus budget reports, which include forecasts and rolling forecasts, which in turn are driven by assumptions and other drivers.

Financial modelling: types

In practice, there are many different types of financial models. We have outlined the 10 most commonly used financial models used by financial modelling professionals.

Three-Statement Model

A three-statement model links the income statement, balance sheet, and cash flow statement into one dynamically connected financial model. These financial models are the basis on which more advanced financial models are built such as discounted cash flow DCF models, merger models, leveraged buyout LBO models, and various other types of financial models.

It falls under both the categories of financial models: Reporting models and Integrated financial statement models.

Discounted Cash Flow (DCF) Model

These types of financial models fall under the category of Valuation models and are typically, though not exclusively, used in equity research and other areas of the capital markets.

A DCF model is a specific type of financial model used to value a business.  DCF model is a forecast of a company’s unlevered free cash flow discounted back to today’s value, which is called the Net Present Value (NPV).

The basic building block of a DCF model is the three-statement financial model, which links the financials together. The DCF model takes the cash flows from the three-statement financial model, makes some adjustments where necessary, and then uses the XNPV function in Excel to discount them back to today at the company’s Weighted Average Cost of Capital (WACC).

Merger Model (M&A)

The M&A model also falls under the Valuation category of financial models.

As the title suggests, this type of financial modelling is towards a more advanced model applied to assess the pro forma accretion/dilution of a merger or acquisition. It’s common to use a single tab model for each company, where the consolidation is represented as Company A + Company B = Merged Co. The level of complexity can vary widely and is most commonly used in investment banking and/or corporate development.

Initial Public Offering (IPO) Model

Like the previous two type to financial models, the IPO model is also a Valuation model.

Financial professionals like investment bankers develop IPO financial models in Excel to value their business just before going public. These financial models equate company analysis with regards to an assumption about how much investors would be willing to pay for the company in contention. The valuation in an IPO model includes an IPO discount to ensure the stock trades well in the secondary financial market.

Leveraged Buyout (LBO) Model

A leveraged buyout (LBO) is a transaction where a company is acquired using debt as the main source of consideration. These transactions typically occur when a private equity (PE) firm borrows as much as they can from a variety of lenders (up to 70 or 80% of the purchase price) and funds the balance with their own equity.

An LBO transaction typically requires financial modelling with debt schedules and are an advanced form of financial models. An LBO is often one of the most detailed and challenging of all types of financial models as they many layers of financing create circular references and require cash flow waterfalls.  These types of models are not very common outside of private equity or investment banking.

When it comes to an LBO transaction, the required financial modelling can get complex. The added complexity comes from the following unique elements of an LBO:

  • High degree of leverage
  • Multiple tranches of debt financing
  • Complex bank covenants
  • Issuing of Preferred shares
  • Management equity compensation
  • Operational improvements targeted in the business

Sum of the Parts Model

Another type of financial model that belongs to the Valuation category of financial models, this model is developed by taking in account a number of DCF financial models and adding them together. Further, any sundry factors of the business that may not be apt for a DCF analysis are added to that value of the business. So, for example, you would sum up, that’s why ‘Sum of the Parts’, the value of business unit A, business unit B, and investments C, minus liabilities D to arrive at the NAV for the company.

Consolidation Model

The Consolidation Model belongs to Reporting Model category of financial models. It includes several business units added into one single model for financial modelling and further analysis. Typically, each business unit is its own tab, with consolidation tab that simply sums up the other business units.  This is similar to a Sum of the Parts exercise where Division A and Division B are added together and a new, consolidated worksheet is created.

Budget Model

The Budget model is used to do financial modelling in financial planning & analysis (FP&A) to get the budget together for the next few years, typically in the range of one, three and five years. Budget financial models are meant to be based on monthly or quarterly figures and rely strongly on the income statement.

This is one more model belonging to the Reporting model category of financial models.

Forecasting Model

Similar to the budget model, the forecasting model is also used in FP&A to come up with a forecast that compares to the budget model. Since it is similar to the forecasting model, it also belongs to the Reporting model category of financial models.

The budget and the forecast models are represented one combined workbook and sometimes they are totally separate.

Option Pricing Model

As the name suggests, this model is part of the Pricing model category of financial models. Binomial tree and Black-Sholes are the two main option pricing financial models and are based purely on mathematical financial modelling rather than specific standards and therefore are an upfront calculator built into Excel.

Though financial modelling is a generic term that means different things to different users, the reference usually relates either to accounting and corporate finance applications, or to quantitative finance applications.

What are the areas where you have applied financial modelling and created financial models for your company or clients? Or what are the other specifics on financial modelling, particular financial models or their application that you might be interested in? Do let us know by writing to us .

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  • Financial Modeling

An Overview of Financial Modeling, Including Examples, Templates, Careers, Salaries and Training Courses

What is financial modeling, and why does it matter.

We get many questions about what “financial modeling” means, how important it is in the finance industry, and why so many students and professionals are obsessed with learning it.

So, let’s start with the basic definition:

Financial Modeling Definition: A financial model is a spreadsheet-based abstraction of a real company that helps you estimate the company’s future cash flows, financing requirements, valuation, and whether or not you should invest in the company; models are also used to assess the viability of acquisitions and the development of new assets.

Suppose that your crazy rich uncle calls you and tells you about his latest investment: a tequila company into which he just “poured” $100,000.

He shares data about the company’s sales, employee count, and market share, and then he claims that his $100,000 investment will be worth $1 million in 5 years.

He then gently encourages you to put your life savings into this tequila company.

Financial Modeling

A robust financial model lets you input these parameters, project the company’s future cash flows, and assess the likelihood of your uncle’s $100,000 investment turning into $1 million in 5 years.

Financial models cannot predict any outcome with a high degree of certainty.

The goal is to be “roughly correct” rather than “precisely wrong.”

If a financial model tells you that a company is undervalued by 5% or 10%, that is a meaningless result because the margin of error is so high.

But if the model tells you that the company is undervalued by 90% or overvalued by 200% , those are much more useful results.

Even if you’re wrong about the percentages, you can still make money if you are directionally correct .

Returning to this tequila company example, perhaps your model produces the following results for your uncle’s $100,000 investment:

  • $1 million in 5 Years: This would require the tequila company to grow from 1% to 10% market share in a very crowded market within 5 years. Alternatively, the company could also get there by selling its tequila at 3x the normal price and capturing 3% of the market.
  • $500,000 in 5 Years: This would require the company to win 5% market share within 5 years or sell its tequila at 2x the normal price while capturing 2% of the market.
  • $200,000 in 5 Years: This would require 3% market share within 5 years or tequila sold for 2x the normal price and 1% of the market (the same as the current share).

What’s the conclusion?

It’s unlikely that your uncle’s $100,000 investment will turn into $1 million within 5 years because the required pricing and market share are unrealistic.

We can’t assign a specific probability to this outcome, but we can say that no food & beverage company in history has ever achieved this performance in this time frame.

  • If the company does achieve this performance, it will likely take more than 5 years.
  • And the other outcomes here, especially the last one, are more plausible.

Doubling or quintupling your money over 5 years is still a great result, so you might take your uncle’s advice and invest some amount.

Or, perhaps you do further research into the company and its market, become more skeptical, and decide against investing.

A financial model is just a PART OF the investment process; it’s like a piece of evidence in a courtroom murder trial.

It can help persuade others that you are correct, but a spreadsheet by itself doesn’t solve the case or convince everyone on the jury.

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Types of Financial Models

There are 4 main categories of financial models used at normal companies, investment banks that advise companies on transactions, and investment firms:

  • Category #1: 3-Statement Models (Income Statement, Balance Sheet, and Cash Flow Statement) or “Budgets” at normal companies (see here for more on 3-Statement Models)
  • Category #2: Valuations and DCF Models (Discounted Cash Flow Models)
  • Category #3: Merger Models (also known as M&A Models or Accretion/Dilution Models)
  • Category #4: Leveraged Buyout Models (slight variations include the Growth Equity Models and “Investment Models”)

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3-Statement Models

In these financial models, you project a company’s revenue, expenses, and cash flow-related line items, such as the Change in Working Capital and Capital Expenditures.

You then use these numbers to forecast the company’s financial statements , i.e., its Income Statement, Balance Sheet, and Cash Flow Statement, over several years.

The Income Statement shows a company’s revenue, expenses, and taxes over a period of time and ends with its Net Income (i.e., its after-tax profits).

The Balance Sheet shows a company’s Assets , or its resources that will deliver future benefits, and its Liabilities & Equity , or its funding sources that have direct or indirect “costs.”

The Cash Flow Statement provides a reconciliation between a company’s Net Income and the cash it generates, which is often quite different.

For example, accounting rules state that cash outflows for spending on long-term items such as factories and properties should not appear directly on the Income Statement because these items could be useful for many years.

So, companies record the cash outflows for this spending as “Capital Expenditures” on the Cash Flow Statement.

If a company buys a new factory for $100 million, its cash flow is reduced by $100 million – but you wouldn’t know it by looking at the Income Statement.

The company’s Income Statement only shows the “Depreciation” representing the allocation of this $100 million over many years.

For example, if the factory is expected to be useful for 20 years, the company might record $100 million / 20 = $5 million of Depreciation per year on its Income Statement.

The Cash Flow Statement records all the cash inflows and outflows, which gives you a full picture of the company’s business health.

It prevents companies from hiding behind non-cash revenue and expenses that might distort their Income Statement.

These 3-statement models are widely used at normal companies for budgeting purposes and at banks and investment firms to assess companies’ financing requirements.

For example, a 3-statement model might tell you that a company will need additional capital in 3-4 years to continue its aggressive expansion strategy:

Cash Flow Statement Financial Modeling Example

If a company has already borrowed money, a 3-statement model might tell you how well it can repay that Debt over the next 5 years.

3-Statement Model Examples

Here are a few examples of 3-statement models:

  • Illinois Tool Works – Sample 3-Statement Modeling Test and Tutorial
  • Industrials Investment Banking – Screenshots from an airline 3-statement model
  • Healthcare Investment Banking – Screenshots from a bio/pharma 3-statement model

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Valuations and DCF Models

In valuation models, you estimate the range of values an entire company might be worth today .

For example, if a public company’s market capitalization (market cap) is $10 billion, is it overvalued, undervalued, or appropriately valued?

Should it be worth closer to $5 billion, or something closer to $15 billion?

Valuations are designed to answer these questions.

You can value a company using different methodologies, but two of the most important ones are the Discounted Cash Flow (DCF) analysis and trading multiples , also called “comparable companies,” “public comps,” or “ comparable company analysis .”

In a DCF, you project a company’s cash flows far into the future (5, 10, or even 20+ years) and discount them to their “Present Value” – what they’re worth today, assuming that you could invest your money elsewhere at a certain rate of return.

With trading multiples, you calculate other companies’ values relative to their financial metrics, such as revenue or profits, and you apply those “multiples” to value your company.

For example, if similar companies are worth 3x their annual revenue, and your company has revenue of $200 million, perhaps it should be worth about $600 million.

In a DCF model, similar to the 3-statement models above, you start by projecting the company’s revenue, expenses, and cash flow line items.

Unlike 3-statement models, however, you do not need the full Income Statement, Balance Sheet, or Cash Flow Statement.

Many of the items on these statements are non-recurring or have nothing to do with the company’s core business, so a partial Income Statement and Cash Flow Statement are sufficient:

Partial Income Statement used in Financial Modeling

This approach saves time and results in nearly the same output in most cases.

Valuation and DCF Model Examples

You can get examples of valuation and DCF models below:

  • Comparable Company Analysis
  • Uber Valuation
  • Snap Valuation
  • DCF Model – Walmart Valuation

The Walmart example also explains the “big idea” behind valuation and DCF analysis.

Merger Models (AKA M&A Models or Accretion/Dilution Models)

A merger model is different because it involves two companies rather than one.

The goal is to assess whether a larger company’s acquisition of a smaller company provides a financial benefit .

For example, will the acquirer’s Earnings per Share (EPS), defined as Net Income / Shares Outstanding, increase after the acquisition closes?

Will the acquirer’s valuation increase after it acquires the target company and properly integrates it?

Is the acquirer paying a fair price for the target based on the financial metrics of both companies?

If the acquirer is issuing new stock (shares) to acquire the target, will each company own appropriate percentages after the deal closes?

Merger models are designed to answer these types of questions.

Similar to valuations and DCF models, you do not need a company’s full Income Statement, Balance Sheet, and Cash Flow Statement to build a merger model.

You just need the Income Statement and a partial Cash Flow Statement for the acquirer and the target:

Combined Income Statement for Financial Modeling

More complex merger models often include the full financial statements, but they’re not required for a basic analysis.

Other key assumptions include the price paid for the target, the form of consideration (Cash, Debt, or New Shares Issued), and the expected synergies (ways for the combined company to cut costs or increase sales).

As with all other financial models, a merger model is just one piece of evidence in the process of negotiating a deal.

A company’s Board of Directors would never approve of an acquisition solely because of a merger model’s output.

There must be other perceived benefits, such as strategic, market, and competitive advantages from the deal.

For example, maybe the target company gives the acquirer access to a high-growth market that would have taken years to enter independently.

Or maybe the target company has valuable intellectual property (IP) that the acquirer cannot easily develop on its own.

M&A and Merger Model Examples

You can view a few sample M&A and merger model tutorials below:

  • Merger Model Walkthrough: Combining the Income Statements
  • Merger Model: Cash, Debt, and Stock Mix
  • Merger Model Interview Questions: What to Expect

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Leveraged Buyout Models (AKA Growth Equity Models or “Invest Models”)

This last category is a variation on the first category (3-statement models).

We’re listing it separately because most people consider them separate, despite the similarities.

In leveraged buyout models (LBO models), the goal is to calculate the multiple or annualized rate of return you could earn by investing in a company, holding your stake, and eventually selling it.

For example, if a private equity firm acquires a company for $1 billion, operates it for 5 years, and sells it, could it potentially earn an average annualized return of 20%?

Or would that require implausible assumptions, such as the company going from a 10% profit margin to a 30% margin within 5 years?

The full financial statements are not required for these models because the investment returns are linked primarily to the company’s cash flow and cash flow growth rate.

And the “exit value” when the company is sold is usually linked to metrics that act as proxies for cash flow, such as EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) .

As with the other models above, you start building an LBO model by projecting the company’s revenue, expenses, and cash flow line items.

These give you a sense of the company’s Free Cash Flow , or the cash it generates from its core business operations after paying for funding costs, such as interest on Debt:

Debt Repayment Schedule for Financial Modeling

Based on the purchase price, the exit value, and the cash flows generated in the holding period, you can calculate the multiple of invested capital (MOIC) and the internal rate of return (IRR) , also known as the average annualized return.

This model is known as an LBO model or leveraged buyout model because private equity firms use a combination of Debt and Equity to fund acquisitions of entire companies.

It’s similar to buying a home using a down payment and a mortgage, but on a much larger scale.

The private equity firm operates the company, uses the company’s cash flows to repay the Debt, and sells the company after several years.

The need to track this Debt repayment and the associated line items makes the Excel formulas more complex than those used in a standard 3-statement model.

If the private equity firm does not use Debt, the model is much simpler because you need only the cash flow projections, the purchase price, and the exit value.

This variation is often called a “growth equity model” or simply an “investment model.”

Regardless of the model variation, though, the goal is always the same: determine plausible ranges for the multiple of invested capital and the annualized returns.

You can get example LBO models, growth equity models, and leveraged buyout tutorials below:

  • Growth Equity: Full Tutorial and Sample Case Study
  • Simple LBO Model – Case Study and Tutorial
  • IRR vs. Cash-on-Cash Multiples in Leveraged Buyouts and Investments

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Industry-Specific and Specialized Financial Models

In addition to the categories above, there are also specialized financial models in industries such as commercial real estate , project finance , and infrastructure private equity .

In these industries, financial modeling is based 100% on cash flows rather than accounting profits, so the three financial statements are not used.

Revenue and expense projections also differ significantly.

For example, in real estate financial modeling , revenue and expenses are based on individual tenants and the terms of their leases, including annual rent escalations, the expenses paid by the tenant, and the probability of leases expiring.

In project finance and infrastructure, the projections are often based on individual contracts as well – and there may be hundreds or thousands of them.

Another difference is that in addition to modeling the acquisitions of existing assets, you may also model new developments in both these industries.

To do that, you assume that a new development initially draws on Equity (i.e., cash from outside investors) and then switches to Debt once a funding threshold has been met.

When the asset is under development, it does not generate cash flow, so the interest and fees on this Debt are capitalized.

Once the development is complete, a loan refinancing occurs , the construction lenders are repaid, and new lenders fund the stabilized asset.

Specialized Financial Models for Real Estate and Construction

If you want examples of these specialized models, please see our coverage below:

  • Real Estate Financial Modeling
  • The Real Estate Pro-Forma
  • Infrastructure Private Equity
  • Project Finance Jobs

There are model variations in other industries as well.

For example, with oil & gas companies, the Net Asset Value (NAV) model is a variation of the traditional DCF analysis that does not have a Terminal Value – because oil & gas assets have limited economic lives.

Once enough oil or gas is extracted from a field, further extraction is no longer economically viable – even if some resources remain in the ground.

The asset is effectively “dead” until market conditions change.

Therefore, you cannot assume that the asset will keep generating cash flows indefinitely into the future.

With banks and insurance companies, there are DCF variations such as the Dividend Discount Model (DDM) and the Embedded Value (EV) model for life insurance.

These models have some differences, but they still value companies based on their future cash flows or proxies for cash flow, such as dividends.

Which Careers Use Financial Modeling?

The financial models described here are widely used in the following industries:

Financial Modeling in Investment Banking

Investment Banking

Investment Bankers assist companies in raising capital and executing transactions such as mergers and acquisitions (M&A).

Financial Modeling in Private Equity

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.

Financial Modeling in Venture Capital

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.

Financial Modeling in Hedge Funds

Hedge Funds

Hedge fund managers raise capital from institutional investors and accredited investors and invest it in financial assets.

Financial Modeling in Corporate Banking

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.

Financial Modeling in Corporate Development

Corporate Development

Corporate Development focuses on acquisitions, divestitures, joint venture (JV) deals, and partnerships internally at a company.

Financial Modeling in Equity Research

Equity Research

Equity research relates to the sell-side role at investment banks where you make Buy, Sell, and Hold recommendations on public stocks.

Financial Modeling Salaries

If you look at the articles above, you’ll see compensation estimates for fields such as investment banking, private equity, and hedge funds.

As a senior professional in these industries, you can earn $1 million+ if you count the base salary, bonus, and other incentive-based compensation.

However, you rarely do “financial modeling” at the senior levels in these fields.

Senior-level roles are almost always sales or negotiation jobs , where your role is to generate revenue by bringing in new clients, raising capital, or closing deals.

Most of the financial modeling is done by junior-to-mid-level professionals, such as Analysts, Associates, and Vice Presidents.

The total compensation for these roles might range from $100K USD on the low end up to $500K USD depending on the industry, firm size, and location.

For example, Investment Banking Analysts often earn total compensation in the $150K – $200K USD range in major financial centers in the U.S.

Private Equity Associates might earn $150K up to $300K or even $350K, depending on the firm.

And a Vice President will progress toward mid-six-figure compensation.

Outside of these fields, financial models are used in other industries, such as corporate finance , corporate development , and Big 4 Transaction Services .

The compensation in these fields is lower than the ranges quoted above; for more details, please click through to the links above.

How Much Does Financial Modeling Matter for Investment Banking?

If you poke around online, you’ll see a wide range of opinions on the importance of financial modeling:

  • Some people claim you need to know it perfectly, even for entry-level interviews and internships.
  • Others say that it’s overhyped and not that important; they point out that many groups are not especially technical and do not do much Excel-based modeling.
  • And others say it’s only important for the “ exit opportunities ” following investment banking, such as private equity.

As usual, the truth is somewhere in the middle.

You do not need to know financial modeling “perfectly” for entry-level interviews and internships, but you do need a solid base of technical knowledge to be competitive.

For example, how do the 3 financial statements link together? How do you set up a DCF and use it to value a company? What are the trade-offs of different valuation methodologies?

You could memorize the answers to these questions, and that might work to some extent.

But the best way to mastery this technical knowledge is to learn and practice financial modeling. It’s the difference between passively listening to a foreign language and actively practicing by speaking and writing in that language .

Financial modeling matters less for the direct benefit and more for the indirect benefit of mastering the accounting, valuation, and transaction analysis concepts that you’ll be asked about in interviews.

It is true that certain groups in investment banking, such as equity capital markets , do not do much financial modeling work (they spend more time in PowerPoint and Word creating market updates).

But in interviews, they’re still going to test you on the key technical concepts.

Finally, it’s also true that financial modeling is more important in some fields than it is in others.

For example, modeling skills do not matter much in early-stage venture capital investing because investing in startups is a much more qualitative process.

An early-stage startup does not have cash flows to model, and the founder’s personality and drive matter more than any spreadsheet.

But modeling skills matter more at late-stage VC firms and private equity firms since they invest in mature, established companies.

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How to Learn Financial Modeling: Free Tutorials

If you want to learn the fundamentals of the DCF analysis, one of the most important models, you can sign up for our free 3-part tutorial series below:

  • 3-Part Financial Modeling Series: The DCF

This series walks you through each step of the analysis, from projecting the company’s Unlevered DCF to estimating its Discount Rate and Terminal Value.

If you want tutorials on other topics, you can also consult our YouTube channel for hundreds of examples:

  • YouTube – Financial Modeling

Financial Modeling Courses

If you want  comprehensive, structured training that teaches you financial modeling based on global case studies of real companies and deals, here are our most relevant financial modeling courses and packages:

  • Core Financial Modeling – This course gives you a great foundation in accounting, valuation, and M&A and LBO modeling
  • Advanced Financial Modeling – This course delves into more complex models and deal types and is  not for beginners; it’s for professionals with some experience who want to improve their skills even more
  • BIWS Premium – This package combines our Excel, PowerPoint, and Core Financial Modeling training, all at one discounted price
  • BIWS Platinum – And this package gives you  everything we have , for a substantial discount (50%+)

These courses are for candidates who are serious about winning highly competitive internship and full-time offers at banks, private equity firms, and hedge funds.

If you have no interest in working at these firms and you just want quick tips and tricks, these courses are not appropriate for you.

But if you want to gain advanced technical skills, they are perfect.

Of course, there’s more to the job than Excel-based analysis, but mastering the technical side goes a long way toward the rest of the skills.

Core Financial Modeling (BIWS)

Learn Valuation and Financial Modeling

Get a crash course on accounting, 3-statement modeling, valuation, and M&A and LBO modeling with 10+ global case studies.

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What Is a Business Model?

  • Andrea Ovans

definition of a business financial model

A history, from Drucker to Christensen.

A look through HBR’s archives shows that business thinkers use the concept of a “business model” in many different ways, potentially skewing the definition. Many people believe Peter Drucker defined the term in a 1994 article as “assumptions about what a company gets paid for,” but that article never mentions the term business model. Instead, Drucker’s theory of the business was a set of assumptions about what a business will and won’t do, closer to Michael Porter’s definition of strategy. Businesses make assumptions about who their customers and competitors are, as well as about technology and their own strengths and weaknesses. Joan Magretta carries the idea of assumptions into her focus on business modeling, which encompasses the activities associated with both making and selling something. Alex Osterwalder also builds on Drucker’s concept of assumptions in his “business model canvas,” a way of organizing assumptions so that you can compare business models. Introducing a better business model into an existing market is the definition of a disruptive innovation, as written about by Clay Christensen. Rita McGrath offers that your business model is failing when innovations yield smaller and smaller improvements. You can innovate a new model by altering the mix of products and services, postponing decisions, changing the people who make the decisions, or changing incentives in the value chain. Finally, Mark Johnson provides a list of 19 types of business models and the organizations that use them.

In The New, New Thing , Michael Lewis refers to the phrase business model as “a term of art.” And like art itself, it’s one of those things many people feel they can recognize when they see it (especially a particularly clever or terrible one) but can’t quite define.

definition of a business financial model

  • AO Andrea Ovans is a former senior editor at Harvard Business Review.

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Types of Financial Models

The 10 most common types of financial models

Ethan Sweeney

Josh has extensive experience private equity, business development, and investment banking. Josh started his career working as an investment banking  analyst for Barclays  before transitioning to a private equity role Neuberger Berman. Currently, Josh is an Associate in the Strategic Finance Group of Accordion Partners, a  management consulting  firm which advises on, executes, and implements value creation initiatives and 100 day plans for Private Equity-backed companies and their financial sponsors.

Josh graduated Magna Cum Laude from the University of Maryland, College Park with a Bachelor of Science in Finance and is currently an  MBA  candidate at Duke University Fuqua School of Business with a concentration in Corporate Strategy.

  • Three statement model 
  • Discounted cash flow (DCF) model
  • Dividend discount model
  • Comparable company analysis model
  • Merger model (M&A)
  • Initial public offering (IPO) model
  • Leveraged buyout (LBO) model
  • Sum of the parts model
  • Budget model
  • Forecasting model
  • Option pricing model
  • Pricing models

Both investors and companies rely on financial models to make key business decisions on where to invest and how to allocate funds. Hence, it is of utmost importance to understand these models for a career in finance.

definition of a business financial model

Many of these models are built to analyze financial ratios and the relationship between various financial metrics. In many cases, analyzing various companies will have industry-specific variables that are valuable for comparison. As financial models primarily involve analyzing historical financial statements of companies, it is extremely helpful to have some knowledge of accounting to assist in the interpretation and creation of these models.

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Financial models are speculative, and forecasts are not always accurate. It can be very hard to accurately predict the future values of securities , as many professionals develop different methods over time and use different ratios that they believe best reflect the market . 

In some cases, models with few variables can be the most reliable because those with more variables are based on more assumptions about the future and may not be consistently reliable.

Top 10 Types of Financial Models

In this article, we cover the top ten types of financial models used by finance professionals and two more used by specialists in certain niche financial roles.

Below is a list of the ten most common types of financial models (+ 2 bonus models):

  • Three statement model  
  • Discounted cash flow ( DCF ) model
  • Merger model (M&A) 
  • Initial public offering (IPO) model 
  • Forecasting model 
  • Option pricing model 
  • Pricing models 

Examples of Financial Models 

Becoming proficient at creating and interpreting financial models takes time and practice. Below are some of the most commonly used financial models and when they may be used. 

1. Three statement model

The three-statement model is a method of forecasting a company’s growth that relies on the three most important financial statements: The income statement , the cash flow statement , and the balance sheet .

definition of a business financial model

These three statements are put into a spreadsheet such as Excel and linked together so that if any data in one statement is changed, the rest will change accordingly. An important part of this process is making sure that the financial statements are correctly linked together. A key part of building this model is researching the historical financial statements of the company.

Investors will perform horizontal and vertical analyses of these statements, making sure to look at past growth and trends of the company as well as overall performance.

Another key part of this model is to look at important and relevant financial ratios . These ratios allow the company to make assumptions about its future growth and the ways in which the business model may change in the years to come. 

Once the necessary assumptions are estimated, an investor can work on creating a forecasted income statement . After this statement is created, an investor can create a forecasted balance sheet , income statements, and cash flow statement .

This model is a good way to organize the forecasts for a business as well as its earnings and expenses. It is generally used as a base for many other more complex financial models.

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To Help you Thrive in the Most Prestigious Jobs on Wall Street.

2. Discounted cash flow (DCF) model

The discounted cash flow model is a method of analysis that predicts whether or not an investment will be profitable based on the cash flow it generates. The generated cash flow is discounted using the desired rate of return, which is called the discount rate and takes into account the time value of money. This method generally uses the three-statement model as a starting point for its assumptions about growth if investing in a company. 

definition of a business financial model

Once an investor builds a three-statement model and calculates the forecasted growth and expected returns for each year of the investment, they can forecast the future cash flows which are then discounted to reflect the net present value (NPV) of the returns. Usually, a company’s discount rate is calculated by finding its weighted average cost of capital (WACC) . The equation to discount the net cash flow on investment looks like this:

Discounted cash flow = R / (1 + d) n

where, R = Given years net cash flow, d = Discount rate, and n = Number of years since the initial investment. 

This equation is used for each year of forecasted net cash flow and added together to arrive at the value of discounted cash flows. This sum is considered the net present value of the investment, and when greater than the cost, it means the investment surpassed the desired rate of return and may be a worthwhile investment.

As with any business valuation methodology, there are many adjustments that can be made to improve its accuracy. One such adjustment is to add back taxes and inflation into the equation, both of which are not accounted for in traditional DCF models.

Below is a useful video about setting up a discounted cash flow model from our DCF Modeling Course .

DCF Modeling Course

Everything You Need To Master DCF Modeling

To Help You Thrive in the Most Prestigious Jobs on Wall Street.

3. Dividend discount model

The dividend discount model is a common method of valuing stocks. One weakness of this model is that the stock being analyzed must offer a dividend . 

definition of a business financial model

This method proposes that a company’s share price is equal to the sum of the present value of all of the company’s future dividends.

Because dividends are a part of a company’s earnings that are paid to stockholders, this model proposes that an increase in dividends is related to a company’s overall growth and revenue and that dividends can be used to estimate a company’s profit. The most common version of the dividend discount model is the Gordon growth model . 

To use this method, an investor must forecast future dividend payments. Usually, investors look at past dividend payments to forecast future dividends. The Gordon growth model assumes a constant rate of growth for dividends, although not all methods of the dividend discount model do. The Gordon growth model equation is as follows:

Share price = D 1 / (r - g)

where, D 1 = Forecasted dividend price for the next year, r = Company’s cost of equity , and g = Estimated constant growth rate. 

The result of this equation is considered to be the intrinsic value of the company, and if it is greater than the company’s actual share price, it is considered undervalued and a good investment, and vice versa.

4. Comparable company analysis model

The comparable company analysis model is a common way to value security and is often used in conjunction with other models to arrive at a value for a given stock. Rather than looking at a security’s intrinsic value , this method uses its extrinsic value based on comparisons to similar companies. It requires comparing relevant and important company metrics to industry averages and other companies of similar size within the same industry.

definition of a business financial model

This method allows the investor to look at how other similar companies are performing and base the value of a company on industry performance. It is best done by creating a table of different industry-relevant metrics and including multiple businesses within each industry to compare and contrast them. It is also good to include industry averages as a baseline to compare each company against another.

This method can be utilized very effectively when combined with a top-down approach. For example, if macro factors in the economy are forecasted to be favorable for a specific industry, it could be beneficial to compare the different companies before investing.

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5. merger model (m&a).

The merger model is used to value a company’s tangible assets and the cash flows those assets generate. The merger model may be used if investors would like to forecast the result of a merger or acquisition or if a company is considering merging with another company.

definition of a business financial model

This model is more complicated than other valuation models because it involves forecasting the effects of a transaction with many variables involved. This also involves building multiple types of financial models to build the merger model.

Usually, the process involves creating a three-statement model for both companies and using these models to forecast their growth. Finally, an investor will value both companies, usually using a discounted cash flow model and comparable company analysis.

Investors will combine the forecasted balance sheets of both companies to understand the results of the merger. This involves making many changes in both the companies’ (acquirer and acquiree) balance sheets based on assumptions about how they will change due to the merger.

One such variable may be the purchasing price of the company being bought. The process of generating extra value by the two companies due to the merger is called synergy. Some important synergies to consider might be a reduction of costs and how each company’s segments may be able to merge to improve overall efficiency.

definition of a business financial model

Usually, companies merge because they believe that the value of the businesses together is greater than their separate values and that their business models complement each other. In many cases, a company will acquire its supplier in a vertical merger, which can reduce input costs for the company.

Synergy is often one of the reasons companies merge and should be considered when finding the company’s new value. Once the companies’ balance sheets are merged, an accretion / dilution analysis is initiated. This process estimates whether the company’s earnings per share (EPS) will rise or fall due to the merger, accretion being an increase in EPS and dilution being a fall in EPS.

The Merger process is divided into three steps: discover, analyze, and negotiate. In discovery, the target company identifies potential targets for acquisition or merger. The target’s financial records are then analyzed using financial models that derive an appropriate value for the target company by considering all of its tangible and intangible assets.

Once this value is calculated, it can be compared with the acquirer’s stock valuation to determine whether the proposed deal makes economic sense. Finally, negotiations start once both parties are willing to go through with a deal. Generally, the acquirer will already have a price range that it is willing to purchase the company for that would be profitable for the acquiring company before starting negotiations.

Learn more about M&A models in the video below.

M&A Modeling Course

Everything You Need To Master M&A Modeling

6. initial public offering (ipo) model.

The initial public offering (IPO) model is a stock distribution strategy that involves the first sale of stock of a new or existing company to the public. The earliest IPO on record was by a Dutch merchant in 1602. In 1927, the US Securities and Exchange Commission (SEC) established a definition for an IPO that would become standard practice around the world: “the offer and sale of securities by a company in exchange for capital raised from investors through a prospectus or private placement memorandum.”

definition of a business financial model

The initial public offering model is used to value a company and find a price at which it should initially offer its stock. This model can be complicated because it rests on many variables used to predict demand for company shares and its future growth. 

Companies typically look at their financial statements and create a three-statement model to better understand their historical and predicted financial performance . They also tend to use comparable company analysis to contrast themselves with other companies and present how their stocks are expected to perform relatively.

While a company’s intrinsic value is extremely important and certainly affects investor outlook, the most important part of an IPO model is gauging demand for the company’s stocks. In particular, companies do to ensure demand for their stock and good stock performance is to include an IPO discount. This means that it sells the stock at a slightly lower price than what is believed to be its true value, so that demand is higher. 

7. Leveraged buyout (LBO) model

A leveraged buyout ( LBO ) is a form of corporate finance maneuver. As part of it, a company finances its purchase of another company by borrowing money from investors, who typically receive an ownership stake in the acquired company.

This type of acquisition involves two or more companies entering into an acquisition transaction where the acquirer borrows money to acquire the target company. The acquisition generally results in the company taking over management control, while the target company retains its organizational structure and brand name.

In an LBO transaction, and by extension LBO models , debt-to-equity ratios range from 2:1 to 50:1, with the possibility of even higher ratios as well.

An acquiring firm will take on many different types of debt to buy another company as part of an LBO. First, it must ensure that this transaction is profitable after paying interest and debt. The debt is usually paid off from cash flows from the newly acquired business or a business resale later on.

definition of a business financial model

Firms usually look for a minimum internal rate of return (IRR) of 20 - 30% for these types of transactions to make sure that they can cover their debt and still make a sizable profit. This model consists of a firm’s valuation of the company and expected future profit and the debt schedules for debt they are expected to take on. 

A company may perform a valuation using a three-statement model and discounted cash flow analysis. This model may look similar to a merger model but is slightly more complicated because the company must consider a very large and complex debt schedule .

An LBO can increase value for all shareholders involved by increasing operating efficiency and boosting cash flow . It also enables the acquiring entity to have greater access to capital markets than going public or seeking outside financing.

LBO Modeling Course

Everything You Need To Master LBO Modeling

8. sum of the parts model.

The sum of the parts model, also called breakup value analysis, analyzes the different parts of a company individually and then values a company as a sum of its parts. This method is usually useful for fairly large companies and has many different operating segments in different industries. However, in some cases, this method could add up different projects within a company to find its value, even if they are not different segments or industries. 

definition of a business financial model

Analysts using this model look at each business lines separately and value each segment as though it were its own business. This may involve using multiple other models such as the three-statement model, discounted cash flow model , and comparable company analysis to evaluate each separate wing of the business. 

Then, as the name suggests, the analyst will add each of these segment valuations together to arrive at the total enterprise value , meaning the entire company’s value. An equation to find the total sum value of a company from its parts follows:

Total Value = V 1 + V 2 + V 3 … + V n - D + A

where, V = Value of each segment up to n segments, D = Net debt, A = non-operating assets and liabilities. 

As this kind of analysis gives a higher relative valuation compared to other methods, it is generally used to defend a company’s value in the case of a hostile takeover. If it can prove that it is worth more than it is being bought for, it just might be able to fend off a hostile takeover. This type of analysis may also be used to calculate a company’s value post restructuring .

9. Budget model

A budget is a plan for allocating money to achieve a goal. Budgeting is an activity that is usually performed by governments, businesses, individuals, and families.

The budget model is the most common type of financial model because it’s the standard approach used by many government entities and corporate businesses. Three common variables to consider in the creation of a budget model are revenue, cost of goods sold (COGS) , and administrative expenses .

definition of a business financial model

Revenue is the amount of income generated by the company or entity that can be tracked over time, while costs of goods sold vary with changes in volume or units produced. Administrative expenses are salaries and wages paid to employees who produce goods or services for the organization and tend to be stable despite varying production levels.

All three of these variables may be hard to predict. Further, there are many different ways to allocate money across an organization which only increases the complexity of budgeting. Below is a breakdown of the most common methods of budget creation.

Static Budget

It is one of the most straightforward types of budgeting. This type of budgeting involves making fixed forecasts for the year about how much the organization is likely to spend in different endeavors and allocates its funds accordingly.

It is important to keep reasonable expectations in mind when creating this budget because expectations rarely translate into reality. Unfortunately, this model also has the negative consequence of having very little flexibility if it is wrong in its forecasting.

Flexible budget

A flexible budget is a good way of accounting for variables in an organization. This method creates multiple budgets designed to account for changes an organization may see throughout the period for which the budget is created. In many cases, companies will make flexible budgets to compensate for fluctuations in sales.

For example, imagine a company with a static budget going over budget. This looks negative, but the company may have gone over budget because it sold more products than expected and had to pay for more input costs, which is very good. The flexible budget avoids this by presenting multiple scenarios such as when the company sells the expected amount of goods or sells more or less than expected.

Other types of budgets

A zero budget is when a company starts a budget from scratch for each period. This gives management flexibility to choose what goals the organization should set for that period and allocate funds based on what they would like to do. This budget is good for choosing which projects to prioritize and giving them the funding they need.

A rolling budget is when a company budgets for a certain horizon and reassesses to constantly budget a specific amount of time out. For example, if an organization budgets a year out, at the end of one month, it would drop the past month and budget for the month a year out, and continue to do this, hence the name. 

definition of a business financial model

The performance budget model allocates money based on the performance of different segments. For example, this model may consider the return on total assets and asset turnover of different segments to see which one is creating the most revenue and using money efficiently.

Check out this page for a  Budget Analysis Spreadsheet Template .

10. Forecasting model

A forecasting model is a financial model that generates estimates of expected cash flows and future values. It is generally used to estimate a firm’s value on a given date. It is used in the derivation of many other models, such as the discounted cash flow model .

The key inputs for a forecasting model expected cash flows, discount rates, and terminal values (TV) .

Below are examples of forecasting models that are commonly used:

Causal models and the econometric model 

Causal models such as the econometric model determine relationships between variables to establish a reliable forecast. For example, the econometric model may consider current events and how they interact with supply and demand to forecast the future value of a company or project.

Qualitative models and the Delphi model 

Qualitative models such as the Delphi model utilize expert opinion to come to a reasonable conclusion. The Delphi model, which is named after the Oracle of Delphi, assumes that a group of experts are better at forecasting than any single person and usually has multiple rounds of forecasts where experts revise their forecasts based on the forecasts of others.

The time series model uses historical data to predict future company growth patterns. This model works best with large companies and has had reliable growth for multiple years.

In many cases, investors will take a mixed approach to forecast to consider many different factors when valuing a company or proposition.

11. Option pricing model

An option is a contract that gives the buyer the right to purchase a security at a given price in the future. Usually, the size of the contract is 100 units. Options are sold at a premium , and the agreed-upon price of the security is called the strike price (the price from which this option contract becomes profitable to exercise). In many cases, options will expire worthless because the security does not reach its strike price . 

The value of an option contract is determined by its underlying asset price and time to expiration. For example, for a call option , this means that if the price of a stock is expected to increase, then the value for that option on it will increase as well. Conversely, if it assumes a price decrease, the value would drop.

This type of financial model often has several assumptions: volatility and interest rates are two key factors in determining values. Some of the most common option pricing models are described below

Black-Scholes Model

This model was created based on European options , which operate slightly differently than American options in that you cannot exercise them before the expiry date. The Black-Scholes model requires the following inputs: 

  • Strike price
  • The risk-free interest rate
  • Time until expiration
  • The price of the underlying asset. 

This equation assumes that the security will move as per the geometric Brownian motion. This model is considered one of the best option pricing models and hence is widely used.

Binomial Model

This model calculates multiple iterations of movement in the stock price and creates two potential paths from each iteration. It contains a binomial tree meaning that each potential price then branches off into potential price movements, either up or down. Investors calculate the probability of these movements and the option’s value at each node and work back to find the option’s current value based on potential future values and the probability of where the price moves.

Trinomial Model

This model is more advanced than the binomial model because rather than taking into account only two possibilities, it takes three possbilities. This is known as a trinomial tree because it includes three trajectories for the security, going up, going down, or staying the same price, and estimates multiple iterations of this movement. This model then aims to calculate the probability of each of these scenarios and the options prices at each node and work backward to find the option’s current value.

12. Pricing models

Pricing models determine how much a company should charge for a particular product or service. It can be determined in several ways. Most importantly, a company needs to consider forecasted demand for their product or service and the costs that they incur to deliver the product or service, which varies based on how many units are sold.

One way to determine the price of a product is called cost-based pricing, which takes the costs of creating the product and multiplies that figure by a profit percentage to derive a desired rate of return. Sometimes a fixed amount is added to achieve a desired absolute profit per unit.

Another way to choose a product’s price is by using value-based pricing, which considers the demand from customers rather than the cost of production.

This pricing model can be much more difficult because it considers a much more variable set of data: Customer’s demand. It is very difficult to estimate what the product will be worth to customers especially considering the fact that different customers will value it differently. This method usually relies on customer feedback or the history of related products.

Competition-based pricing involves looking at the prices of competing products that could act as substitutes for the product and basing the price off similar market prices. In competitive markets, sellers are known to be “price takers,” meaning that they must sell their products at the market price or else the customers will buy substitute products from competitors. This type of pricing strategy follows that notion.

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Detailed guide to the financial modeling definition and its types

Detailed guide to the financial modeling definition and its types

Mergers and acquisitions are complex financial transactions with numerous levels and stages. With that in mind, the M&A community aims to provide business leaders and company executives with the most relevant M&A insights, as well as assist them in conducting complex M&A deals for the first time. 

The following article prepared by the M&A community covers financial modeling as part of M&A deals. 

By the end of the reading, you’ll know the definition of financial modeling and its types, discover industry-specific financial models, and learn the main financial modeling tools. Besides, the article provides financial modeling examples that demonstrate what a financial model of a particular type includes.

What is financial modeling: Basics of financial modeling

Financial modeling is a process of building a numerical illustration of a company’s financial activity in the past, present, and forecasted future. Financial models are usually spreadsheet-based.

Financial models are often used as decision-making tools when a company’s executives expect to assess a new project or acquisition’s potential costs, risks, and profits.

Financial modeling and business valuation also aim to decide on budgets, allocate corporate finance resources, define the cost of upcoming projects, and forecast the impact of a specific future event on the company’s stock.

Note: Learn how to do stock pitch in our dedicated article.

Below are the key components of financial modeling:

  • Assumptions and drivers
  • Income statement
  • Charts and graphs
  • Cash flow statement
  • Sensitivity analysis
  • Balance sheet
  • Supporting schedules

What is financial modeling used for?

Executives of a target company opt for financial modeling to decide on:

  • Capital allocation
  • Financial analysis
  • Selling business units and assets as a part of divestiture strategy
  • Growing the business organically (entering new markets, exploring new locations, opening new stores)
  • Planning potential cash flows for upcoming years
  • Valuing the business
  • Management accounting
  • Making acquisitions
  • Raising capital

Types of financial modeling

Professionals outline many types of financial modeling, but let’s define the 10 most frequently used by financial analysts.

1. Three-statement 

This is the basic financial modeling setup. Such financial models always include three financial statements: income statement, balance sheet, and cash flow statement . There are also supporting schedules. As a rule, these financial statements are dynamically linked to Excel files.

With these financial models, you can plan your company’s expenses and revenue. 

  • The income statement includes particulars about the revenues, expenses, and taxes of a target company over some time as well as its net income.
  • The balance sheet showcases the company’s resources or assets that are to deliver benefits in the future.
  • The cash flow statement presents the reconciliation between net income and generated cash.

2. Discounted cash flow (DCF) 

Discounted cash flow analysis builds on the three-statement financial model. It calculates the value of a target company and its free cash flow based on the net present value (NPV) of the business’s future cash flows.

By opting for discounted cash flow analysis, the company’s owners can find out whether its stock is undervalued or overvalued. This type of financial model is usually used in equity research and other capital market areas. 

DCF modeling determines the attractiveness of the potential investment opportunity.

3. Merger and acquisition (M&A)

M&A financial models are used to forecast the profits or losses of a potential merger or acquisition. It primarily aims to figure out the effect on the earnings per share (EPS) of the combined company after closing the deal.

If EPS increases as a result of the merger, then the deal is considered accretive. And if EPS decreases, the transaction is regarded as dilutive.

When building financial models of this type, financial analysts generally use a single tap model for each company, where Company A + Company B = Merged Co.

Investment banking or corporate finance specialists usually build financial models of M&A type.

4. Initial public offering (IPO)

An IPO financial model is used when a company wants to assess its business in advance of going public. Such financial models aim to make a comparative analysis of the company and assume the cost potential investors would be willing to pay for it. 

The assessment in an IPO financial model includes an IPO discount to ensure good stock trading in the secondary market.

The IPO financial model is frequently used in the sphere of corporate development and investment banking.

5. Leveraged buyout (LBO)

In a leveraged buyout deal, one company acquires another company with borrowed (debt) money. Due to this, LBO financial models are more advanced and usually are built on complex formulas. 

This financial structure always requires modeling a complicated debt schedule. Its main goal is to figure out the amount of profit a certain company can generate from such a deal.

LBO financial models are rarely used outside private equity and investment banking industries.

6. Consolidation

The consolidation type of financial modeling suggests multiple businesses uniting into one single model.

As a rule, this financial model includes a separate tab for each business, with a consolidation tab that simply sums up all organizational units. 

The consolidation financial model allows for calculating the possible revenue growth after companies’ consolidation.

The budget financial model aims to forecast the company’s budget for upcoming years. 

Budget financial models imply the analysis of the company’s figures over the last month or quarter and target the income statement mainly.

Budget modeling helps to better understand your company’s financials and, thus, plan the budget for the upcoming period more effectively. That’s the main reason for this financial model usage.

8. Forecasting

The forecasting financial model is often combined with the budget financial model, as they have a similar goal: to compare budgets and make forecasts for the upcoming year (or years). 

It’s usually used in financial planning and analysis and helps specialists to understand the company’s attractiveness to potential investors.

9. Option pricing

Option pricing models aim to define the theoretical value of an options contract. This financial model is based on mathematical formulas and complex calculations and is basically a straightforward calculator built in Excel files. It’s mostly used by investors to determine the true value of an option.

There are three types of option pricing financial modeling:

This model diagrammatically presents possible prices during different periods and uses either a two-period binomial tree or a multi-period binomial tree. The binomial financial model is mostly used to value American options.

  • Black-Scholes

This financial model operates on five input variables: strike price, volatility, risk-free rate, underlying asset price, and expiration time. It’s mostly used to value European options.

  • Monte Carlo simulation

This model usually includes the application of integration, optimization, and probability distribution. Worldwide investors and financial analysts use it to evaluate the probable success of upcoming investments.

10. Sum-of-the-parts

A sum-of-the-parts financial model presupposes taking several DCF models and summing them up. 

This is especially advantageous when valuing a huge conglomerate. Financial analysts value each unit separately and then add them together to get the valuation of the whole conglomerate.

This financial model helps to understand the true value of the company, which is especially important in investment banking. 

Financial modeling for different spheres

Besides the 10 common types of financial models described above, there are also industry-specific types of financial modeling. 

Let’s shortly review the main industries where financial modeling is used.

Real estate

In real estate financial modeling, you analyze the property from the Equity Investor (owner) and Debt Investor’s (lender) point of view. 

Commercial real estate aims to determine whether the property is worth investment and project possible risks and potential returns.

Real estate financial analysis is purely based on cash flows.

Private equity

Private equity financial modeling usually aims to assess the return profile of purchasing a business and consists of leverage buyout financial models.

The main metrics of private equity financial modeling are debt/equity ratio, cash on cash return, net present value, internal rate of return (IRR), and debt/EBITDA ratio.

Venture capital

Venture capital financial modeling implies creating venture funds. Modeling venture funds usually implies two models:

  • Model for the fund (the entity that will make investments)
  • Model for the management company (the entity that will manage the fund)

In a venture capital financial model, venture capitalists expect to see the company’s financial situation over more than a year.

SaaS financial modeling

Financial modeling valuation for SaaS companies is a crucial stage of the growth plan.

SaaS businesses typically come with high costs at the early stage. This is because a SaaS product needs to attract lots of new customers from the very start, and this always comes with high spending. 

The SaaS financial modeling includes a review of the business’s revenues and expenses, as well as forecasts on future revenue and important KPIs.

The key elements of the SaaS financial model are:

  • Profit and loss statement or income statement — demonstrates expenses and profits before taxes
  • Revenue model — demonstrates the revenue at the end of every month
  • Unit economics — calculates the profitability of each business unit

Investment banking

Investment banking financial modeling is used to evaluate the company’s present financial performance as well as forecast its future performance.

Financial modeling investment banking allows deciding on the potential investment.

Mergers and acquisitions

M&A financial modeling is often a part of the due diligence process. It aims to determine the potential firm’s cost of the upcoming merger or acquisition by evaluating possible profits and losses. 

An advanced financial modeler in the M&A industry typically chooses such types of business financial modeling as comparable company analysis, three-statement modeling, and DCF financial model.

As a rule, financial modeling for startups is done to forecast the emerging company’s capital costs, expenses, employees, customers, and revenues.

Financial modeling for start up helps to evaluate the viability of the future business and avoid losses or overspending.

Financial modeling tools

The most common and popular tool used for financial modeling prep is MS Excel. It has all the functions financial analysts need when creating a financial model. The main reason for using MS Excel are:

  • It’s particularly affordable for any business type and size
  • It’s easy to audit
  • It frequently integrates with other types of financial work done in Excel
  • It’s easy to use, even at a basic level
  • It’s flexible and dynamic

Still, there are specialized software products that make the financial modeling process more efficient and straightforward. Some software tools are:

Financial modeling examples

Below are three examples of financial modeling based on its type.

  • Three-statement

The screenshot below demonstrates the balance sheet section of a three-statement single worksheet financial model. The model also includes an income statement, cash flow statement, supporting schedules, and assumptions. Each section can be expanded or contracted to view each model separately.

definition of a business financial model

The following DCF financial model screenshot consists of a balance sheet, free cash flow statement, assumptions and drivers, income statement, supporting schedules, and discounted cash flow model sheet. The latter shows historical data and forecasted results.

definition of a business financial model

The leveraged buyout model demonstrates the fully developed financial statements, credit metrics, debt modeling, multiple operating scenarios, cash-on-cash and IRR, and sensitivity analysis.

definition of a business financial model

Financial modeling is a spreadsheet-based numerical illustration of a company’s past, present, and forecasted financials that helps to evaluate a company’s potential. 

The main types of financial models are:

  • Sum-of-the-parts
  • Consolidation
  • Forecasting
  • Option pricing

There are also such industry-specific types of financial models as real estate, investment banking, venture capital, mergers and acquisitions, startups, and SaaS. 

The main tool financial analysts use for creating financial models is MS Excel. However, there are also modern software products that make the financial modeling process simpler.

Other insights

definition of a business financial model

Are IPOs coming back?

definition of a business financial model

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on July 17, 2023

Are You Retirement Ready?

Table of contents, business model definition.

A business model is a high-level plan for how a business will earn and maximize profits .

Business models establish whether a company will offer a product or service, be online or brick and mortar, or sell to businesses vs directly to consumers, or a hybrid between several traditional business models.

A business model is not an in-depth plan; it is a 30,000 ft view of the business which is used as a platform to build more in-depth plans upon.

A business model has 2 main focuses: a marketing plan and a financial plan.

Marketing Plan

Within a marketing plan, a company must establish its Value Proposition, Brand, and Target Market.

  • A Value Proposition is why customers should want to purchase a product or service from you instead of a competitor . For example, Uber's value proposition is a 24/7 fleet of drivers in your area to take you from point A to point B.
  • A Brand is how you communicate your value proposition to your customers and what consumers think of when they hear your company's name. While TJMaxx and Abercrombie both sell clothing, TJMaxx is a cheaper alternative while Abercrombie positions itself as premium casual wear.
  • A target market is who you are trying to sell to. A target market can be based on age, gender, marital status, location, life stage, job or a variety of other factors.

Here is a marketing plan example:

Financial Plan

A financial plan forecasts revenues while assessing variable and fixed costs .

Variable costs are costs associated with each unit of production, which are used to calculate the profit earned from each unit sold, known as " gross profit ."

Fixed costs are the necessary overhead costs to produce goods, such as a facility.

A financial plan will evaluate how many units must be sold to cover fixed costs and become profitable.

Invest in Growth and Protection

Every business' goal is to earn and maximize profits. However, many business owners fail to consider the many other factors that can potentially harm their businesses.

With the help of a financial advisor who can assess the viability of your business model, potential risks can be minimized or avoided and profitability can be maximized.

Business Model FAQs

What is a business model.

A business model is a high-level plan for how a business will earn and maximize profits and establish whether a company will offer a product or service.

How does a Business Model work?

Why is a business model important.

A business model gives a business definite specific goals that it will try to reach by the end of the time period that the model covers.

What is the purpose of a Business Model?

What are the two primary parts of a business model.

The primary parts of a business model are a marketing plan and a financial plan.

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon , Nasdaq and Forbes .

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More From Forbes

Rethinking business financing norms: challenging the status quo.

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Pace Morby is the cohost of A&E TV series, Triple Digit Flip, and runs one of the largest real estate investing communities, SubTo .

In any saturated market, it’s not always innovative thinking that drives success.

In the cases of Xerox and Apple , it’s obvious that innovators who aren’t applicators can get left behind.

Though innovation can be a major driver of success, overall, those who learn to apply new ideas may be able to achieve a better top line than those who stick to their old ways.

I find myself operating in the world of investment, where ROI is king. Because I’ve learned how to apply creative financing techniques that have already existed for hundreds of years to my businesses, I’ve had a world of opportunity open to me that most investors and entrepreneurs can only dream of.

This can be the possibility for any business owner who is not only willing to learn, but also to apply new ideas that challenge the “traditional way” of doing business—especially those who believe their options are limited by traditional financial constraints.

Challenging The Status Quo

The traditional path to investment, especially in real estate, has long been paved by bank loans and significant personal capital. This means that only those with a significant upfront payment and strong credit scores could hope to even throw their hat in the ring.

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However, this conventional route isn’t the only way, and I’ll argue that it’s not even the safest or smartest way to get started for some. By challenging the status quo and embracing “unconventional methods,” investors can uncover avenues previously thought inaccessible.

The Power Of Perspective

The key to unlocking your potential and the potential earnings of your business lies in perspective. Your perspective influences your outcome. When investors shift their focus from "what is" to "what could be," they discover possibilities they haven’t even thought were possible before. This mindset change is critical for recognizing and capitalizing on opportunities that others might overlook.

I’ve used a variety of nontraditional funding methods —like seller financing and private money lending—that bypass the need for traditional bank loans or large down payments.

Investing In Your Perspective

I am one of literally a dozen kids.

When your parents make a living but aren’t millionaires, finding housing for 14 people can be challenging. My dad learned about creative financing and used it to his advantage to house our family. He saw creative financing as an investment in his family.

Now, I see creative financing as an investment in my family too, but I also see it for the potential it has to help my family have a better financial future. In tandem with my father’s perspective, I’ve used nontraditional financing techniques to change my career path and my income and hopefully change the lives of entrepreneurs everywhere.

Breaking Barriers To Entry

One of the most significant advantages of creative financing is its ability to lower the barriers to entry for new investors. Traditional investment routes often require substantial capital, which is not just a deterrent to the hesitant and skeptical, but also an insurmountable obstacle for some. Some creative financing strategies, on the other hand, can provide pathways to investment with minimal or even no initial capital requirement.

A New Era Of Inclusivity

The investment landscape can become more inclusive with nontraditional financing techniques like seller financing and subject to agreements.

Strategies like these can open doors for individuals who have the acumen and ambition but lack the financial means to embark on investment ventures through conventional routes. This inclusivity not only benefits individual investors but can also contribute to a more diverse and dynamic market.

Who Can Benefit And Where To Start

The landscape of investment is not just evolving; it's undergoing a revolution that’s calling for a new breed of investors—those who don't just adapt to change but drive it.

And this revolution isn’t reserved for a select few, either. It's accessible to all entrepreneurs willing to embrace the journey of continuous learning and diligent application, and the doors are open for anyone prepared to invest time and effort into understanding its intricacies.

But it's about more than just learning the ropes of unconventional financing methods. It’s about cultivating a mindset that sees beyond limitations and perceives opportunities where others see barriers.

Now, entrepreneurs looking to explore creative financing need to start by thoroughly understanding their own financial situation, goals and needs. To help you determine how you as an individual can get started, you can ask yourself questions like:

• How much funding do I need to meet my long-term goal?

• How comfortable am I with identifying and managing risks?

• Do I fully understand the creative financing model, or do I need to build a team to help me accomplish my goals?

Most challenges in creative financing come from navigating the complexity of new financial tools rather than understanding them in concept. Adhering to regulatory and compliance requirements and managing the potential impact on business operations is hard for many small businesses to do on their own.

While it's possible to start using creative financing to pursue success, no one man is a master of all. Preparation for success means educating yourself about methods, seeking advice from financial experts, staying informed about market and regulatory changes, and building a team to help manage all of these things

Creative financing offers more flexibility and potentially quicker access to funds than traditional methods when you understand how to mitigate risks. People who want to utilize creative financing can mitigate risks by doing their due diligence and research to make sure that the long-term financial flow is a net positive, not just in the short term. People may be at risk if they do not use every proper contract and precaution, which can lead to legal trouble. To avoid both of these risks, consider working with a transaction coordinator whose entire job it is to guide you through the right steps.

As you reflect upon your own business practices, consider that the path to success is no longer linear. The future of investment is not just about where you're going and the returns you receive, but also about how you choose to get there.

The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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Organizational health is (still) the key to long-term performance

For decades we’ve seen companies’ fortunes rise and fall based on their ability to react to, and recover quickly from, geopolitical shocks, technological advances, economic uncertainty, competitors’ bold moves, and other disruptions. Amid this volatility, which these days is accelerating rather than abating, many have a hard time staying the course. But some continue to survive and thrive despite the challenges. Why do these companies manage to succeed, year after year—operationally, financially, and otherwise—while others don’t?

Twenty-plus years of proprietary McKinsey research tells us that one of the main reasons is organizational health.

Organizational health refers to how effectively leaders “run the place”—that is, how they make decisions, allocate resources, operate day to day, and lead their teams with the goal of delivering high performance, both near term and over time. Organizational health comprises three elements: how well the entire organization rallies around a common vision and strategy, how well the organization executes its strategy, and how well the organization innovates and renews itself over time.

Our latest research on the topic reiterates the degree to which organizational health is not just nice to have; it’s required for sustained performance and organizational success. McKinsey’s Organizational Health Index (OHI) continues to show, for instance, that, over the long term, healthy organizations deliver three times the total shareholder returns (TSR) of unhealthy organizations, regardless of industry. 1 Aaron De Smet, Bill Schaninger, and Matthew Smith, “ The hidden value of organizational health—and how to capture it ,” McKinsey Quarterly , April 1, 2014. Other findings point to greater resilience and higher financial performance in healthy organizations, even as the world around them has become that much more complicated (see sidebar, “What is the Organizational Health Index?”).

What is the Organizational Health Index?

The Organizational Health Index (OHI) is a diagnostic that measures critical elements of a high-performing culture in an organization. The index draws from a proprietary database of more than eight million respondents across more than 2,500 organizations in a range of geographies and industries. The index aggregates employees’ and managers’ views on the management practices (and employee experiences) that inform an organization’s performance across nine dimensions, or outcomes. An overall score is assigned so companies can see how they compare with others in the database. The result is a detailed view of the health and internal-network dynamics of an organization (exhibit).

Launched in 2003, the OHI model is updated regularly to reflect advances in organizational science and changes in the state of organizations more broadly. The 2023 update includes factors—such as agility, resilience, inclusivity, and employee experience and well-being—that have become more pronounced in the wake of the global pandemic, macroeconomic shifts, geopolitical unease, and other global trends.

In this article, we look at the latest OHI results and highlight a few of the more compelling insights that the index reveals about leadership, data and technology, and talent management. We also identify several principles for building or maintaining organizational health over time—something that leaders often tell us they have limited time and resources to do.

It’s important to make the time, however—not just to spin up new activities but rather to think about how to run the business differently and factor both health and performance into daily actions. The causes of, and conditions for, organizational health are always changing. Just as medical associations continually update their recommendations on diet and fitness, so must the business community regularly monitor its practices and performance. The companies that do can differentiate themselves from others in the marketplace. They can more readily identify the kind of talent they need and the specific behaviors it will take to achieve their organizational objectives.

Organizational health can put companies on a fast track to performance —and a commitment to sustained health can keep them there.

The staying power of organizational health

There is no one right path to sustained success, but the fact is, healthier organizations do tend to perform better than unhealthy ones, especially in times of uncertainty. And that performance advantage increases over time. 2 “ Where companies with a long-term view outperform their peers ,” McKinsey Global Institute, February 8, 2017. According to our research, organizational health is the strongest predictor of value creation and a critical factor in sustained competitive advantage. In one evaluation of 1,500 companies in 100 countries, for instance, we saw that companies that had improved their organizational health realized 18 percent increases in their EBITDA  after one year.

Consider the following data points.

Health and M&A . In merger situations, healthy organizations—those that applied various health interventions during the integration phase and emphasized organizational health throughout the integration—gained a 5 percent median change in TSR  compared with industry peers after two years. The change for unhealthy companies was –17 percent over the same period.

Health and transformations . In large transformations, companies that embedded organizational-health investments and initiatives in their change programs across an 18-month period saw 35 percent higher TSR  than companies that did not invest in health.

Health and resiliency . Healthy organizations are not just higher performers, they are also more resilient and better able to manage downside risk. For instance, from 2020 to 2021, during the COVID-19 pandemic, healthy organizations were 59 percent less likely than unhealthy organizations to show signs of financial distress .

Health and safety . Companies with superior organizational health are better able than their peers to provide safe work environments, thereby limiting their exposure to financial, operational, and reputational risks. Indeed, companies in the top quartile in organizational health have six times fewer safety incidents  than those in the bottom quartile.

The relationship between health and performance can be quantified in other ways, too, including in the areas of talent and culture . In our experience, employees and leaders in unhealthy cultures often focus on what made them successful in the past rather than on what may be required going forward—and their entrenched behaviors and ways of working can take on a life of their own. Consider the situation at one global company: employees had reported in company satisfaction and pulse surveys that they felt motivated to do their jobs—and yet, the company’s performance remained stagnant. The CEO and executive team could not determine how to break through.

An organizational-health diagnostic revealed the problem: misaligned behaviors had dulled the company’s performance edge. Employees were producing day to day—but not in the areas that mattered most for meeting the organization’s long-term strategic goals. They were engaged but comfortable—“like being in a warm bath.” To change the energy, the CEO and executive team embarked on a multiyear transformation in which they reengineered business processes, instituted different working norms for leadership teams, changed their protocols for meetings and communications, activated change agents across the organization, and pushed more decisions down to those on the front lines. Over time, employees’ enthusiasm increased, and descriptions of “what it felt like to work there” became livelier and more focused on achieving great things together. Performance was on the upswing.

A pulse check: How should leaders think about organizational health?

Clearly, organizational health matters as much now as it ever has. The latest OHI results reiterate what we know from McKinsey’s 2023 State of Organizations research  about how companies are faring in an era of unprecedented change. But in these latest OHI findings, three trends in particular stand out: how leaders are leading; the links between technology, data, and innovation; and the value of talent mobility.

1. Leadership is undergoing a generational transformation

It’s fair to say that few—if any—executives anticipated the deeply disruptive business (and societal) changes that would emerge because of the 2020 global pandemic and the speed at which organizations needed to transform themselves. As they have reckoned with changes in where and how work gets done, leaders are learning that they need to be both decisive and empowering .

To that point, the OHI research indicates that decisive leadership is now one of the best predictors of organizational health. Unlike authoritative leadership, in which leaders use influence and authority to get things done, decisive leadership reflects leaders’ quick decisions and their commitment to act on them. During the COVID-19 pandemic, senior leaders at Amazon made quick commitments—within days and weeks, not months—to prioritize essential supplies, protect customers from price gouging, raise the minimum wage for hourly workers, and increase overtime pay. They allowed unlimited paid time off, as well as two weeks of sick pay to those affected by COVID-19. The company also rapidly expanded the capacity in its data center to meet the surge in demand for cloud computing services, which resulted in increased operational efficiency and growth for Amazon Web Services. 3 Karen Weise, “Amazon’s profit soars 220 percent as pandemic drives shopping online,”  New York Times , April 29, 2021.

Would you like to learn more about the Organizational Health Index ?

Decisive leadership is not just for times of crisis, however; it’s a requirement for any business that just wants to keep up. 4 Aaron De Smet, Gerald Lackey, and Leigh M. Weiss, “ Untangling your organization’s decision making ,” McKinsey Quarterly , June 21, 2017. To that end, a number of organizations have taken steps to empower frontline workers. Senior leaders at TJ Maxx, for instance, have empowered more than 1,200 buyers across all stores, each of whom controls millions of dollars, to cut deals on the spot with manufacturers. By committing to a system of delegated decision making, leaders have ensured that items get into stores quicker—within a week, in most cases—than they would have under a more traditional, hierarchical review process. 5 “The Economics of T.J. Maxx’s recession-proof pricing strategy, explained,” Wall Street Journal , June 1, 2023. Leaders at Southwest Airlines have made a concerted effort to put critical customer information in frontline employees’ hands: “Not only are [employees] able to work more quickly, but they are also providing a more tailored experience to customers,” James Ashworth, vice president for customer support and services, told Forbes magazine. The end result has been “a lift in our customer satisfaction scores, as well as a decrease in our call handle times,” he says. 6 Tiffani Bova, “Southwest on the importance of employee experience,” Forbes , November 17, 2020.

According to the OHI research, companies with leaders who take decisive actions—and who commit to those decisions once they are made—are 4.2 times more likely to be healthy, as compared with their peers.

But it’s not enough just to be fast with those decisions; our OHI research shows that decisive leaders who empower their employees (giving those closest to the work the autonomy to make their own decisions) are 85 percent more likely to improve the quality of organizational decisions, as compared with their peers. This supports previous McKinsey research pointing to a paradigm shift in leadership and, among other new requirements, the need for executives to shift from being controllers to becoming coaches  who engage employees and help foster in them a bold mindset of testing, learning, and fast adaptation. 7 Aaron De Smet, Arne Gast, Johanne Lavoie, and Michael Lurie, “ New leadership for a new era of thriving organizations ,”  McKinsey Quarterly , May 4, 2023.

Bank Mandiri, for instance, is using digital tools to ensure that individuals across all parts of the company have access to data analytics. Previously, information requests and report generation at the bank could take weeks, and critical business information had to be pulled from a tangle of systems. Through a new self-service system, employees can now access the data that are most relevant to them in a timelier manner—in a matter of days rather than weeks—allowing employees to make better, faster decisions.

2. Data is the fuel for everyday innovation

Leaders have traditionally thought of innovation as a process for bringing “the next big idea” to life . But our latest OHI data reveal that companies are more likely to succeed with innovation initiatives if “big bang ideas” are supported by data-driven insights and supplemented with smaller, more frequent ideas that target improvements in everyday processes or ways of working.

In many organizations, the ideas for “little i” innovation often come from the people closest to customers— frontline employees . 8 People & Organization Blog , “ Empower the front line for a thriving organization ,” blog entry by Kelli Moles and Michael Park, McKinsey, August 28, 2023. And, as it turns out, it pays to listen to them: the OHI data show that organizations that actively listen and act on recommendations from frontline employees are 80 percent more likely than others to consistently implement new and better ways of doing things.

The research also reiterates that all forms of innovation are more likely to succeed when decisions are grounded in data and facts. According to the research, organizations that emphasize data-driven decision making are 63 percent more likely than others to adapt to a changing business environment.

One of the best recent examples of data-informed innovation comes from Major League Baseball. The rise of data analytics prompted significant changes in many teams’ operations; managers built their rosters and managed their lineups according to batting percentages, probabilities, and other data captured across the league. The downside of that data-driven innovation, however, was longer games (more pitching changes) and a product that was less appealing to younger viewers. Again, the league turned to data—this time conducting surveys, focus groups, and spending time with younger fans—to learn what was important to them. Based on that feedback, the league engaged in some experiments. It implemented rule changes in 2023 (pitch clocks, larger bases, pitching-change limits, and so on) that fundamentally altered the pace and action of the game. The league continues to embrace innovation and technology, not only to improve the game but the overall fan experience. 9 Erik Roth, “ The Committed Innovator: How Major League Baseball built an innovation machine ,” McKinsey, October 27, 2023.

3. The dynamic deployment of talent is becoming even more of a competitive advantage

Workforce dynamics have been completely upended over the past few years, which has left organizations with an increasingly difficult HR-related task: ensuring that they have the right talent on board to tackle the highest-value-creating activities and successfully execute on their strategies. 10 Patrick Guggenberger, Dana Maor, Michael Park, and Patrick Simon, “ The State of Organizations 2023: Ten shifts transforming organizations ,” McKinsey, April 26, 2023. Our OHI research shows that the dynamic deployment of talent can be a powerful lever for both employee attraction and retention. It can also help organizations pivot quickly as markets change or new technologies and global trends emerge. 

Companies that encourage and even facilitate internal role changes can sharpen employees’ skills, maximize their versatility, and provide avenues for growth. According to our OHI findings, employees that experience more mobility at work are 27 percent less likely to report feeling burned out, 47 percent less likely to report intentions to leave their organization, and 2.3 times more likely to recommend their companies to others.

Employee rotations and upskilling became core components of one Latin American bank’s digital transformation. When HR leaders realized that 62 percent of the company’s technology workforce needed to be upskilled to meet the bank’s transformation goals, they launched a large training initiative, which involved more than 1,500 courses focused on about 820 technology skills, 60 boot camps, and countless individual, on-the-job coaching sessions. The HR organization embedded this focus on technology coaching and capability building into all performance management discussions.

As a result of this effort, about 60 percent of the total technology workforce is engaged in upskilling, attrition is low, and what started as a “special transformation program” is now considered business as usual and a cornerstone of the bank’s learning and development efforts. 11 Vincent Bérubé, Dana Maor, Maria Ocampo, and Alex Sukharevsky, “ HR rewired: An end-to-end approach to attracting and retaining top tech talent ,” McKinsey, June 27, 2023.

It's worth noting that more and more organizations are following the bank’s lead and exploring the move to skills-based hiring —in part to address shortages in certain skill areas like technology but also to create pathways for “nontraditional” job candidates, or those who might not have a college degree or a formal certificate of expertise. 12 Bryan Hancock and Brooke Weddle, “ Right skills, right person, right role ,” McKinsey, October 25, 2023.

Getting and staying healthy

Sustained organizational success really comes down to leaders gathering the data that will help them understand which behaviors can help them to meet their performance goals as well as the type and scale of health improvements their organization should target.

It’s critical for leaders to establish a baseline of the organization’s current strengths as well as the strengths it is targeting. With that baseline in mind, leaders can set clear behavioral priorities and begin to act—but it’s also critical to remember that context matters. Organizations will need to launch health interventions that are specific to the business, their performance goals, and their customer value proposition. Two hotel chains—one luxury, one economy—may offer similar services in the market, but each requires different kinds of behaviors to deliver on their value propositions and meet their performance targets. Regardless of their starting points, each will need to track progress against goals and adapt as needed along the way.

McKinsey research points to four foundational behaviors, what we call power practices , that can have disproportionate effects on organizational performance—and whose absence can create a significant drag on organizations: strategic clarity, role clarity, personal ownership, and competitive insights. 13 It is worth noting that the list of power practices has changed over time, and likely will again, but three practices routinely show up: strategic clarity, role clarity, and personal ownership.

  • Strategic clarity . Healthy organizations effectively translate vision and strategy into actionable and measurable objectives that are clearly articulated and shared with employees at all levels.
  • Role clarity . Healthy organizations tend to have structures, processes, and working norms that speed up decision making, remove layers of bureaucracy, and make it easy for employees to get things done—even when situations are new or ambiguous.
  • Personal ownership . Healthy organizations hire and develop managers who have a deep sense of personal ownership for their work and who foster that same sense of ownership in their teams and employees.
  • Competitive insights . Healthy organizations tend to have a clear view of where and how they fit in the competitive landscape and of their value propositions; they use these insights to set strategic priorities, make decisions, and allocate resources.

If any of these power practices are missing or at risk, organizations should take steps to address them; it’s a no-regrets move for achieving good organizational health.

In addition to this list, companies also need to identify which kinds of talent and behaviors are required for them to truly differentiate themselves from competitors—the organizations’ so-called “secret sauce.” Industry insights and benchmarks can provide some direction, but the final list of behaviors that convey competitive advantage to one company and not others can only be identified by an organization’s senior leaders.

The “born remote” technology company GitLab provides a good example. Long before these days of remote and hybrid workplaces, the company established foundational norms  to get the most out of its distributed workforce. Ways of working were designed to be independent of time and place. Employees are encouraged to “write things down,” for instance, and playbooks are readily available online. GitLab’s operating model emphasizes a shared reality, equal contributions, decision velocity, and measurement clarity. The central behaviors at the company’s core have given it an advantage as other companies continue to try to define remote and hybrid working models . And GitLab has demonstrated top-decile performance against OHI benchmarks. As this and many other examples show, leaders in outperforming companies always have a plan to be “good enough” at everything and “truly excellent” at the handful of things that matter for them and the organization. And when it comes to how they run the place, they emphasize cultural consistency across the organization. 14 Carolyn Dewar and Scott Keller, “Three steps to a high-performance culture,” Harvard Business Review , January 26, 2012.

The leadership imperative

Our research makes a clear and compelling case that organizational health is the foundation for companies’ ability to successfully create value, attain profitability, build resilience, and thrive in so many other areas.

So why don’t more senior executives make it a priority?

In our experience, there are several common obstacles. The first is inconsistency in how leaders think and talk about organizational health: conversations about organizational health often anchor on employee engagement as the default, and executives often consider organizational health as being separate from performance. In fact, they are actually one and the same. Leaders should be asking themselves, “How do I run the place each and every day—in each and every meeting—in ways that are both healthy and conducive to creating high performance?”

Related, senior leaders may not see the trees for the forest; many will discuss organizational health as a top-level theme but are much less often involved in the interventions and implementation required to achieve and sustain organizational health. Third, realizing improvements in organizational health takes time—and executives often need to move fast. The default here is to focus on putting out fires rather than fixing the system.

And finally, there’s a sense that bad health implies bad leadership. C-suite leaders must make organizational health a central component of their leadership styles and manage it as rigorously as they do their P&L. Otherwise, they may not actually recognize unhealthy actions when they see them. For this reason, leaders may need to spend extra time, attention, and resources on health interventions. They may need to reframe quarterly discussions and incentives and other elements of performance management around the idea of maintaining organizational health.

Even for those companies that are seemingly in great shape, it’s important to continue to monitor the organization for symptoms of upset or disruption. Just as top athletes can lose time or distance or skill if they skip workouts for an extended period, so can companies fall behind competitors if they take a break and rest on their laurels. Commitment is crucial.

Alex Camp is a partner in McKinsey’s New York office, Arne Gast is a senior partner in the Amsterdam office, Drew Goldstein is a partner in the Charlotte, North Carolina, office, and Brooke Weddle is a partner in the Washington, DC, office.

The authors wish to thank Aaron De Smet,  Ben Fletcher, David Mendelsohn, John Parsons, and Laura Pineault for their contributions to this article.

This article was edited by Roberta Fusaro, an editorial director in the Boston office.

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Subscription Business Model Defined, How It Works, Examples

definition of a business financial model

What Is a Subscription Business Model? 

Subscription business models are based on the idea of selling a product or service to receive monthly or yearly recurring subscription revenue . They focus on customer retention over customer acquisition. In essence, subscription business models focus on the way revenue is made so that a single customer pays multiple payments for prolonged access to a good or service instead of a large upfront one-time price. Now, the economy is trending toward more subscriptions instead of ownership for cars, software, entertainment, and shopping. This increases the lifetime value (LTV) of the customer.

Key Takeaways

  • Subscription businesses involve selling a product or service and collecting recurring revenue for continuing to provide that service or product.
  • Most subscription businesses charge either monthly or yearly. 
  • One of the first and easiest to understand subscription business models is magazine subscriptions.
  • Thanks to the rise of technology, many businesses are moving from one-time purchases to subscription models.

How Subscription Business Models Work 

Subscription business models were first introduced in the 1600s by newspaper and book publishers. With the rise of technology and software as a service (SaaS) products, many companies are moving from a business revenue model where revenue is made from a customer's one-time purchase to a subscription model where revenue is made on a recurring basis in return for consistent access to the delivery of a good or service.

The subscriptions are generally renewed and activated automatically with a pre-authorized credit card or checking account.  The benefit of subscription business models is the recurring revenue, which also helps create strong customer relationships. 

Types of Subscription Business Models 

Subscription business models can include a variety of companies and industries. Those industries include cable television, satellite radio, websites, gyms, lawn care, storage units, and many more. 

In addition, there are newer-aged businesses that operate subscription models, such as subscription boxes. Subscription box businesses include meal delivery services and meal delivery kits. As well, there are subscription business models for accessing online storage for documents and photos, such as the Apple iCloud.  

Beyond that, there are products that are shipped directly to your home, such as personal care products. Companies in this area include Dollar Shave Club and Birchbox.

Car subscription services provide you with access to a vehicle in exchange for a monthly fee. Vehicle subscriptions may include registration, maintenance, roadside assistance, and  liability insurance . Unlike a lease, which requires a two- to four-year term, you can subscribe to a car service for a shorter time frame, and you can swap out your car for a new one every month.

Example of a Subscription Business Model  

The easiest subscription business model to understand is that of a magazine company. Instead of selling a magazine as a standalone product where a customer makes a one-time purchase, magazine companies offer a subscription service for the delivery of a weekly or monthly magazine. In this model, instead of having customers make single purchases, magazine companies offer monthly payments for a yearly subscription to access their monthly magazines.

If a magazine company offers a monthly magazine service, instead of as a single magazine purchase, it offers its service as a 12-month service comprising 12 purchases. This makes the revenue model of the company stronger because it guarantees itself sales over a 12-month period rather than a single purchase. This makes revenue forecasting and business planning easier since a company can project its sales farther out with more accuracy.

Magazine companies are not the only model that uses a subscription business model. With technology, almost any product or service can now be a subscription model.

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