Financial Modeling of proforma returns is a task that should be performed by every business, annually. It is the act of quantifying the anticipated revenues and expenses, associated with implementing your business strategy. While the expected outcome of a Balance Sheet or Statement of Cash Flow can be completed, the statement modeled will most likely be the Income Statement.
The primary driver of the success of this process is related to the quality of the assumptions used, i.e. data based estimate vs. a gut guestimate. The ease of choosing assumptions is directly related to the age of your company –
- Established businesses within a mature industry – The assumptions used will be mainly based on the history of your company, but slightly modified to take into account your strategy. The model output would be an annual budget.
- New businesses within an established industry – The assumptions used will be based on the activities of competitors, whose business model closely match yours, but slightly modified to take into account your strategy. The model output should be a three to five year plan.
- New business for a new or young industry – Assumptions chosen should be conservative assumptions provided by senior managers of your company, i.e. the experts. The model output should be a three to five year plan.
The first model produced is your expected scenario. Now produce two more models, i.e. run the model for revenues 25% greater than previously expected and 50% lower than expected. This process is valuable to understand what you will do if actual results differ from your first model projection. If your company is 25% more profitable than expected, what will you do with the enhanced revenue? If your company is 50% less profitable than expected, will you survive the next 12 months of Operations?
Once the model(s) are completed, the iterative analysis process should begin. Understand the drivers of revenues and expenses. What adjustments can be made to cost inputs and revenue strategies that could create different results? What Risk components (opportunity, threats) alter this cost vs. revenue relationship. Adjust the model accordingly and re-analyze.
The process discussed can be completed by any experienced modeler using a spreadsheet program, to predict the economic outcome of any business, new product or service. A more in-depth analysis can be performed (Monte Carlo Methods/Simulations) using a statistical package or spreadsheet “add-in” that can model the probability of different events occurring, based on changing variables.
The last and final step – document the model. Document the assumptions you employed so monthly you can compare actual results to plan results. This documentation will help you understand the cause if a variance exists.
What is your experience?