Financial Forecasting & Modeling – What They Are & Why Use Them

Jack ChangManaging Director, DGP Capital

Wouldn’t it be nice to be able to predict the future?  As a business owner or operations manager, being able to predict what will happen in the economy, within your industry sector and your company next quarter or next year would clearly be an advantage.  While crystal balls don’t exist, forward-looking financial models can help management teams make informed estimates about business trends and future performance.  

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Macroeconomic factors are complex and dynamic; designing a financial model that accurately identifies and then anticipates macroeconomic effects on a company provides valuable data for management teams to proactively respond, rather than just react.  Forward looking financial models provide an analysis of projected scenarios through a spreadsheet that uses numeric financial data expressed in formulaic relationships. 

The outputs from these formulaic relationships can then be turned into graphics or dashboards. This makes those outputs easier to quickly grasp and communicate to others.

Financial forecasting and financial Modeling are two type complimentary tools that produce estimates of various potential scenarios, and can be tailored to communicate relevant data points to owners, investors, managers and creditors.

Financial Modeling Begins With A Good Financial Forecasting Tool

Financial Forecasts are informed predictions about what will happen with particular items such as sales, expenses, gross margins, overhead costs and general profitability.  

  • Qualitative Forecasting deals with words and meaning, and is highly reliant on industry experts creating tools based on relevant assumptions on key variables. It is focused on exploring ideas and experiences, and is typically short-term with a narrow focus.  Examples include: market research, polling, and customer surveys.  
  • Quantitative Forecasting generally utilizes historical and statistical data to test hypotheses based on that data. It deals with numbers and statistics and all aspects of it can be counted, measured, and expressed using numbers. Examples include backlog analysis, sales growth, and economic forecasting.  

The goal with each is to obtain a valid estimate of future results expressed in numerical figures.  The resulting values assist management teams in making decisions that support the achievement of their company’s objectives.  

Financial Modeling Calculates The Impact Of Financial Forecasts

Forecasts, while helpful, do not paint the whole picture with respect to how a company is impacted by forecasts, and how it will achieve its performance goals. By linking the relationship between all the performance, operational and other factors of a company with forecasts, financial analysts can have a higher degree of accuracy in charting the future performance of a company.  Combining multiple financial forecasts into a repeatable, predictive result on a broader scale is the main purpose of Financial Modeling.  

Creating formulaic relationships between key inputs and forecasts, and financial metrics, is the key to creating a financial model that management teams can depend on for guiding key business decisions.

Value Of Financial Modeling: Bringing It All Together

Financial modeling helps management teams plan and prepare for potential future events.  By quantifying the effects between key operational and financial factors, management can modify variables within the model and observe how the overall business is affected by specific scenarios. The model can also be analyzed historically to understand what happened to the company and why. Examples of financial modeling use cases include:

  • Financial performance estimates
  • Valuation of a company or asset
  • Equity investment analysis
  • Sensitivity analysis / pricing strategies
  • Discounted cash flow analysis
  • Historical effects investigations
  • Project finance analysis
  • M&A / restructuring analysis
  • Capital structure / debt and financing analysis
  • Pro forma financial statements

Limitations Of Financial Modeling: Cautionary Note To Remember

Predicting the future of a company is fraught with difficulties, and by no means fool-proof.  Forecasting and modeling, while being powerful tools, are only as good as the source data and assumed effects within the formulas.  

Read our recent article discussing EBITDA and potential distortions of company financials.  

Using incorrect or distorted financial data and other inputs within a financial model simply amplifies the initial data distortions, and may yield highly inaccurate estimates.  Misunderstanding or incorrectly interpreting the relationship between factors, or their impact on financial results, will also reduce the accuracy of modeling.  

That being said, how can financial models be improved? One approach is to utilize historical data sets to check the accuracy of the model.  Assumptions and formulas can then be fine-tuned and re-run until accuracy relative to actual results is achieved.  Typically, the narrower the financial model’s predictive scope, the higher the expected accuracy will be.  This all helps improve the power of financial models as a management tool, but it doesn’t overcome situations where new significant business factors might arise and alter a model’s accuracy.  

Conclusion: Financial Models Are Useful Tools For All Business Owners

Despite these challenges, financial models typically provide far more insight to business owners or management teams than personal experience or intuition can provide.  When used appropriately, financial models help business owners assess their company’s performance, and adjust operations to meet or exceed budgeted goals.

Commonly used types of financial models include:

  1. Three Statement – the most basic financial model dynamically connects the items of the income statement and balance sheet with the statement of cash flow. 
  2. Discounted Cash Flow (DCF) – using the Three Statement model of future cash flow, the company’s value is then discounted back to obtain a current value.
  3. Merger (M&A) – used to evaluate the effects of a merger/acquisition to obtain a value of the consolidated new entity.  The complexity of this type model varies greatly.
  4. Initial Public Offering (IPO) – by using analysis of comparable companies and estimating investors’ interest, a stock price value is obtained.
  5. Leveraged Buyout (LBO) – used to obtain a company’s value under multiple layers of financing.  The layers create circular references leading this model to be the most detailed and difficult to construct well.  It is mostly used by private equity or investment banking firms. 
  6. Consolidation – separate financial modeling is run on divisions within a company and then the individual values are summed into consolidated values.
  7. Sum of the Parts – an analysis of a company’s valuation derived from adding the values from multiple DCF models for separate business units within the company, plus any components outside the scope of DCF analysis.
  8. Budget – an estimate of financial targets for a company using monthly or quarterly financial figures.

Knowing “why” a result will occur is usually the key to avoiding unpleasant results or to being positioned to benefit.  Robust financial modeling can help uncover the “why’s” for your business, and empower key decision makers.