Financial Modeling Mistakes to Avoid
What Is Financial Modeling? How to Build Financial Models & Avoid Common Pitfalls
Financial modeling is an integral part of any business’ forward-looking financial planning. Contrary to popular opinion, increasing revenue and returns are not as simple as “turning on the faucet.”
In order for revenue and returns to follow growth, you’ll need to model exactly HOW you’ll get there, which is where financial modeling comes in. What is financial modeling? How does it keep your business organized? Keep reading to find out.
What Are Financial Models?
Financial modeling is a financial analysis skill that uses accounting, business metrics, and finance to represent the business at a future date. It is also a tool used in forecasting that relies on key assumptions to perform calculations and make recommendations based on that information.
Good models are built out using varying assumptions because of the somewhat unpredictable nature of forecasting.
By modeling the results of a range of values for each assumption, you can see if your business is on track to meet your goals or if you’re headed for trouble. Models inform financial planning, helping you set and reach better goals over time.
How to Use a Financial Model
With proper use, financial models can help leadership teams make strategic decisions, predict financial outcomes, and test different business scenarios based on informed data.
It’s important to note that there are many different types of financial models, each of which serves a specific purpose. If you’re unsure what type of financial model would suit your needs, look over these 10 types of financial models. It’s not remotely exhaustive, but it offers a solid foundation.
Depending on how you structure them, financial models can be extremely helpful in making informed business decisions like:
- Allocating capital to specific projects or keeping it
- Choosing to go public or not
- Expanding the business organically or staying the same
- Keeping or selling business assets
- Needing to raise capital or not
- Opening or postponing a new product line
- Passing on or making acquisitions/mergers
- Raising or shrinking the quarterly budget for the entire sale year
Additionally, providing potential or current investors with financial models will inspire confidence in your company’s strategic direction and make deals easier to achieve.
How to Build Financial Models
Each financial model requires different steps unique to its approach. However, most models follow the same basic outline.
1. Look at and Add the Historical Results
When creating a financial model, it’s always good to look at the past to build a foundation to work from. Around three years’ worth of financial statements, investment choices, and other financial data makes a good baseline to work with.
This data displays different trends that occurred and how they were handled, giving you the context necessary to navigate similar trends in the future. This historical data will greatly influence your forecasts, so ensure that all the data is accurate.
2. Generate the Income Statement
An income statement shows company profits and expenses. It’s split into operating and non-operating capital.
It’s a crucial part of financial modeling because every company and investor needs to know how the business performed in a single fiscal year. An income statement highlights changes in areas like gross profits, direct costs, and different aspects of capital that can change every fiscal quarter.
3. Fill Out the Balance Sheet
A balance sheet shows a company’s financial health by listing equity, assets, and liabilities. Sometimes balance sheets and income statements are mistaken for the same thing, but they are different. An income statement shows a business’s performance for a specific period, and a balance sheet shows what a company owns and owes.
Write the Property, Plant, and Equipment Schedule
Part of filling out the balance sheet is writing the property, plant, and equipment (PP&E) schedule. Also known as fixed assets, PP&E fall under the noncurrent asset category—which means they have value for years but it depreciates over time. Noncurrent assets include:
- Bonds
- Copyrights
- Equipment
- Furniture
- Patents
- Property
- Vehicles
Because these assets don’t change dramatically like more volatile assets, it’s important to keep track of their depreciation schedule.
4. Create the Cash Flow Statement
A cash flow statement shows how much cash a business makes and how that cash has been used during the fiscal quarter or year. This portion of the financial model includes actions like investing or paying debt.
5. Forecasting
Now that you have all the foundational information in your financial model, you can create forecasts for your business. This data feeds various models that show potential versions of the future depending on different changeable factors.
Most forecasting models are for three to five years in the future.
If you choose to, you can focus on specific items like revenue margins, changes in market trends, or growth opportunities/risks.
Avoiding the Pitfalls of Modeling
While financial models can be very useful in forecasting and planning, the model is only as good as the one building it and the assumptions feeding into it. When building a model, be sure to avoid these common mistakes.
Pulling from Incorrect Financials
Because many models pull from financial statements, if your statements are a mess, it’s probably safe to say that your model will be too. Be sure your financials are accurate and up-to-date before building a model that relies on them.
In most businesses, this requires having appropriate controls and processes in place so that the model is correct going forward. Not sure where to start? Here’s an article on when to hire a CFO that may help.
Building a Concrete Model
As with most planning and forecasting, it’s nearly impossible to get every aspect of a model 100% correct. That’s why it’s so important that models are living, breathing documents. As time goes on, assumptions change, and your business progresses, you can use your model as a template, adjusting the levers and assumptions as needed.
Don’t make it too difficult to alter your assumptions; you’ll save yourself a ton of time by not building additional models when an update gets the job done.
Trying to Nail Down One Assumption
Assumptions are the core of a model. Yet, while incorrect assumptions lead to incorrect recommendations, making accurate assumptions is genuinely tough—especially as you model out further in the future.
Instead of trying to nail down an estimate, aim for a range of values for that particular assumption. Then, use the model to calculate the different outcomes for a few different values in the range. Modeling this way also gives you a set of expectations should things go awry. Now that you’ve got a few different outcomes to work with, you can plan for the best and the worst.
Using Too Many Assumptions
The more informed your model is, the more information it can give you about your business. However, there is a point where using more assumptions doesn’t provide additional benefit.
Particularly in startups, it’s difficult to assume anything very far into the future, let alone make accurate assumptions for 20 different factors. Though spending hours planning and calculating every assumption may seem beneficial, Dave Chase, CFO and director at Amplēo, suggests focusing on 5–15 assumptions that you can really hone in on. You’ll save time and get a more accurate model in the process.
How Amplēo Can Help
Financial models can be effective tools for planning and forecasting. By modeling out revenue, businesses can more readily “turn on the faucet” and begin reaping the rewards.
If building out financial models seems like too time-consuming a task, partner with Amplēo. Our consultants are experts in modeling and forecasting. We offer the full suite of financial services, from CFOs to controllers and accountants.
Contact Amplēo today to learn how our financial model experts can help you. You can trust that your business is in the hands of seasoned veterans, ready to take your business to the next level.
Additional Resources When Building Financial Models
If you’re looking for more resources to improve your financial model-building skills, make sure to review:
