Financial Modeling is an Art, not a Science

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?

Author: Regis Quirin
Visit Regis's Website - Email Regis
Regis Quirin is a financial executive with 23 years of corporate experience, i.e. New York Stock Exchange, JP Morgan Chase, and GMAC ResCap; and 15 years working with small and medium-sized entities, i.e. joint ventures, start-up entities, established businesses. In 2014, Regis published "Redesign to Turnaround Underperforming Small and Medium-Sized Businesses" available via Amazon.
© Copyright 2012 Regis Quirin, All rights Reserved. Written For: CFO Tips - What you need to know, to be a CFO TODAY!

Regis Quirin

Regis Quirin is a financial executive with 23 years of corporate experience, i.e. New York Stock Exchange, JP Morgan Chase, and GMAC ResCap; and 15 years working with small and medium-sized entities, i.e. joint ventures, start-up entities, established businesses. In 2014, Regis published "Redesign to Turnaround Underperforming Small and Medium-Sized Businesses" available via Amazon.

35 thoughts on “Financial Modeling is an Art, not a Science

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  13. Great comments. I have spent my career developing models for 100’s of business situations and as you indicated it’s as much “art” as it is science. I’ve always been in favor of a zero based approach with a keen eye toward the “Drivers”. To be effective you need to be part engineer, part salesman and all accountant/analyst. I have found that if you miss the high growth side of the model you run out of cash for things like inventory and receivables. Costs are easy to predict, but sales are impossible, but revenues rule the process.

  14. I agree with your approach of senstivity analysis though 25% up and 50% down is too wide in my opinion.
    generally, we senstize by increasing/reducing sales and gross profit by 10,15 or 20%
    we are a medium size private company so excess profits means abetter bonus for employees and more equity or dividends for the owner.
    it also puts us in a better mood to look for acquisitions or invest in new systems to facilitate our work

    1. Your numbers make sense as you are an established company and have some history. I like your approach of having sensitivities three up from expected and three below. Thank you for your comment.

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