F-Cube Series – Finance Fundamentals for Founders – Financial Modeling (Part 3) – How to create a financial model

In Part 2, we looked into the reason to use financial models and the kind of analysis you could do as a Founder or CEO to get actionable insights for decision-making. In this post, we will touch upon how to create a high-functioning financial model. We will cover this topic in detail in future posts – this post merely introduces the possibilities.

To recap, the financial model is a tool that businesses use to predict future performance. The most important part of creating a financial model is ensuring that you have accurate data. Once you have the data, the next step is to break it down into the different components that will make up your financial model. This article will walk you through the different pieces of a financial model and what goes into each one. By understanding all of the components, you’ll be able to create a financial model that effectively predicts your company’s future performance.

The first step is to determine how to forecast your business model. You can use either of two primary methods: bottom-up analysis or top-down analysis.

What is the top-down approach?

The top-down approach is based on assumptions about what might happen to the topline and is more often than not driven by sales targets of the business. This type of forecasting can be used for long-term planning purposes, when the business is strongly correlated with the economic environment. In this case, the topline numbers and sales targets are driven by factors such as consumer sentiment, interest rates and inflation levels to name a few in the consumer-oriented businesses. 

In practice, the top-line approach works well when the CEO sets the sales targets i.e. he/she determines how much of business is to be executed as well as associated direct costs and expenses to arrive at profitability.

What is the bottom-up approach?

Bottom-up approach dissects the business drivers into as much granularity or details as possible and each driver is forecasted to arrive at a top-line and margins. If done monthly, the approach offers an unmatched level of clarity on future expectations along with managing finances and cash-flows of the business. 

Bottom-up analysis is conducted typically if the team has a finance expert available and the team is able to give adequate time for data collection and construction. The annual operating plan or budgeting done at the start of the financial year, by Financial Planning and Analysis (FP&A) teams generally take up this approach.

Having touched upon  the two primary approaches to modeling, some of the general steps that apply in any financial model building are:

• Identify key assumptions or variables that will define the outcome of the project
• Once you have identified these assumptions, create mathematical linkages for each variable-this will help you better assess how changes in these variables would affect your final outcome
• The next step is to develop scenarios that show what might happen if one or more of those assumptions change over time

The model can then help you to understand and visualize how your business will grow over time – what its cash flow and profitability will look like.

If you’re not sure where to start, there are plenty of resources available online and in the Fynmodels Portal, or you can consult with a financial professional. Creating a financial model is an important step in starting any business, so don’t hesitate to get started today!

F-Cube Series: This is part 3 of 5-part series of blog posts

1. What is a Financial Model
2. Why use a financial model
3. How to create a financial model
4. Types of models in finance
5. Use-cases of financial models