Financial modeling is the process of converting data and assumptions into a projection of future economic outcome.
For Debt Modeling
Typically, a financial model for debt instruments utilizes the parameters of the financial instrument – the debt balance, the term and the loan coupon – to generate a ‘pristine’ model of what cash flows will result in a ‘pristine’ situation… that is if the contract terms are fulfilled completely with no options exercised.
Once the pristine cash flows of a debt instrument are understood, then various scenarios are overlaid the pristine flows – to estimate what would happen if certain options are exercised. For example, with many debt instruments, the borrower is able to repay the loan balance early with little or no repayment penalty. The likelihood of the early repayment option being exercised increases if interest rates fall and the borrower can refinance at a reduced cost of borrowing. Consequently, most investors evaluate the value of a debt instrument by utilizing some expected distribution of future interest rates. For each scenario of future interest rates, a separate estimate of cash flows will result – with the probability of repayment in each period corresponding to some comparison of the relative cost of borrowing in that future period.
In addition to early debt repayment, many financial models incorporate some expected distribution of future borrower defaults. The distribution of defaults may incorporate economic conditions that might be expected. The distribution of defaults will also most certainly incorporate the historical record of defaults by similar borrowers. When loan defaults (and the corresponding payment delinquencies) are incorporated into financial models, the models often become quite complex, with not only estimates of delayed and missing payments, but also estimates of asset recoveries when the loans are collateralized – with corresponding costs estimated which might be associated with the recovery process (e.g., legal costs, or the cost of repossessing an automobile and shipping it off to auction).
The major categories of risks that are incorporated into debt-type cash flow models include market risks (such as with the future interest rates that might become available), credit risks (that is, the frequency of defaults and delinquencies for the borrower population), and operational risks (the operating risks associated with the lender and associated service providers).
For Business Cash Flow Modeling
Many businesses are valued based upon the net cash flow after expenses. These business models are often dependent upon estimates of customer growth, of new products introduced, the estimated future costs associated with producing a product and with other business risks.
The business cash flow projections can be as varied as the business type. Often, financial models and business analysis rely upon ‘common-sized’ financial statements that are collected and shared among business-financing institutions. With these common-sized statements, businesses are grouped by type of business and by size (in terms of turn over), and financial statements are presented with each type of income and expense as an expected relationship with sales or income.
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