April 26, 2022 by Adam Hoeksema
Financial forecasting models can be a financial analyst's best friend. Financial forecasting is the process of using data from past performance and current trends to make financial predictions about the future. Models use these forecasts to create a picture of what reality might look like when their predictions come true.
Forecasting is important for businesses because it allows them to make informed decisions about where to allocate resources and how to plan for future growth. There are many different methods and models of financial forecasting, and here we will discuss the most popular and useful ones.
The Importance of Financial Forecasting
Forecasting financial performance involves determining how well a company will perform in the future based on its past and present performances. Forecasting is important for businesses because it allows them to:
- Make informed business decisions
- Plan where to allocate resources
- Predict future expenses
- Plan for future growth
There are many different methods of forecasting, but most businesses use a combination of historical analysis, trend analysis, and market analysis. Businesses typically forecast revenue, gross margin, and SG&A expenses (sales, general, and administrative expenses).
Forecasting revenue is important because it provides a baseline for measuring performance and an idea of what the future will bring, based on this baseline. Businesses can use revenue forecasts to track revenue progress over time.
Revenue forecasts can be used to:
- Identify trends
- Assess opportunities for growth
- Set sales goals
For example, if a business notices through forecasting that its revenue is increasing at a slower rate than the overall market, it may want to investigate new product development or expansion into new markets.
Forecasting Gross Margin
This is usually measured as a percentage of revenue. Gross margin forecasts are important because they provide insight into profitability when revenue isn’t telling the whole story.
Businesses can use gross margin forecasts to:
- Set prices
- Make inventory decisions
- Assess the financial health of the business
For example, if a business notices that its gross margins are decreasing, it may want to investigate ways to reduce costs or increase prices.
Forecasting SG&A Expenses
SG&A expense forecasts are important because they provide insight into the financial health of the business. SG&A stands for Selling, General, and Administrative Expenses, and forecasting will illuminate areas to adjust spending in order to stay within budgets over the course of the forecast.
Businesses can use SG&A expense forecasts to:
- Assess cash flow
- Set budgets
- Make strategic decisions about where to allocate resources
For example, if a business notices that its SG&A expenses are increasing faster than revenue, it may want to investigate ways to reduce costs.
The Differences Between Financial Forecasting vs Financial Modeling
When it comes to financial planning, businesses and individuals alike need to be able to look into the future and make predictions about what might happen. This is where financial forecasting and financial modeling come in. Though these two terms are often used interchangeably, they refer to two different processes.
- Financial forecasting is primarily concerned with making short-term predictions based on historical data.
- Financial modeling is a more forward-looking process that involves building a detailed model of how a business or individual's finances might evolve over time.
While both forecasting and modeling can help make strategic decisions, they each have their own strengths and weaknesses. As such, it's important to understand the difference between the two before choosing which approach to use. Here are the two concepts in a little more detail.
Financial forecasting is the process of estimating short-term future financial performance based on past financial performance. Forecasting is typically done using financial ratios, such as sales growth rate or profitability, that have been calculated for a historical period.
This data is then used to estimate how these ratios might change in the future. Financial forecasting is often used to make short-term predictions, such as estimating the next quarter's sales.
However, it can also be used to make longer-term predictions, such as estimating the financial impact of a new product launch.
A financial forecast gives educated predictions about the company’s future in the near term; often a year or less. It comes in handy when figuring out the annual budget and running financial risk assessments and it helps by using solid statistics to make better business decisions for the financial year.
Essentially, a forecast is what upper management predicts will occur and the financial outcomes of those occurrences. A forecast is what will be presented to stockholders and be made publicly available.
Financial modeling is the process of building a model that shows how a business or individual's finances might evolve over time.
Models are typically built using spreadsheet software, such as Microsoft Excel.
Like Financial forecasts, financial models can also be used to make short-term predictions, such as estimating the financial impact of a new product launch.
However, they are primarily used to make long-term predictions, such as estimating the financial impact of a new business strategy. They do this by focusing on the effects of changes in variables over time.
By tweaking variables such as salaries or marketing budgets, models can be used to simulate different scenarios, such as what would happen if a company launched a new product or if interest rates increased. This makes financial modeling an essential tool for strategic planning.
The main obvious difference between the two approaches is the period they cover. While forecasting predicts outcomes over an accounting period, models can be used to take a look well into the future.
The other differences are in the details; models can predict the future outcomes of more than just base estimates of a company’s performance – often by combining different financial forecasts into a unified model.
This makes the financial model a much more in-depth and long-term assessment of potential outcomes, as opposed to the financial forecast, which suggests a single outcome based on an expected trajectory. However, both are forms of forecasting, and this is where some of the confusion in terminology can lie.
Finally, models are usually more adaptable and can be modified with new or suggested inputs to assess the change in outcomes these inputs lead to.
To make things simpler, it’s worth considering that a model is a simplified representation of reality. By removing superfluous information, a financial model can create a detailed depiction of what’s important to the future and how it will look. When inputs are changed, the model changes to represent the projected reality based on the new inputs.
When financial forecasts are combined into a financial forecasting model, it’s useful to use five or more forecasts and a variety of strategies to make sense of them. Here are some of the financial forecasting methods that can be combined into a model.
Understanding a Financial Model
So, how do you get from one to the other? In forecast financial modeling, most methods involve taking current cash flow forecasts and weighing them against the risks. This is the fundamental principle of a financial model.
Once it’s completed, the model should be able to feed numerous values into it and receive a single predicted statement of a future condition. This may be a detailed financial depiction or a simple binary metric of success and failure.
Either way, a financial model allows businesses to focus on goals and risks without including distracting details. A good model is simple enough to understand but detailed enough to be accurate. Decision-makers need to be able to understand the key drivers of cash flow and success that come out of the model in order to act upon them correctly.
The model also needs to assert the conclusions found as clear assumptions to be discussed and agreed upon by the decision-makers. Essentially, the model is designed to help people understand the complexities and risks of business decisions.
Yet, with all the strengths of a strong financial model, businesses often overlook them in favor of instinct and rough calculations. These can be somewhat effective strategies in some contexts, but ultimately there is no substitute for a financial forecasting model.
So how does a financial model work? There are two types of approaches:
- Stochastic – these methods use complex calculations and probability theory to include random effects in the model. The outcomes are probabilistic estimates of the results of the starting conditions combined with random variables. This is a good approach for areas where there is a lot of uncertainty, such as the stock market and investment portfolios.
- Deterministic – these set fixed assumptions based on their inputs. Since there is no randomness incorporated, the results from a single set of inputs will always be the same. Uncertainty is not included in this model, and its relatively simple design makes it useful for tweaking variables to measure the impacts of potential changes without the result being clouded by random variables.
With this in mind, what are the best and most-used financial forecasting models used today?
Top 3 Financial Forecasting Models
While there are too many models to list here, the following three methods to forecast financial modeling are particularly well-suited for startups and small businesses and cover a range of applications:
1. The Discounted Cash Flow (DCF) Model
The DCF model helps to ascertain the value of an investment based on how much capital it will generate in the future. The primary way it does this is by using the WACC formula.
The Weighted Average Cost of Capital (WACC) formula is a valuation technique that is used to estimate the cost of equity and debt financing for a company. This formula considers the different risks associated with different types of financing, which makes it an ideal tool for businesses that are seeking to minimize their costs of capital.
It takes the financing of the firm; for example, debt and equity. WACC calculates the cost for both of these, factoring in certain elements such as taxation, and gives them a weight in order to project into future scenarios.
Essentially, the calculations in this model begin with identifying the proportion of the financing that comes from equity and then running the same calculation for interest-bearing debt. These are then multiplied by their associated costs to give a weighting. This acts as a ratio for projections.
This formula takes into account the cost of acquiring capital and may mix in models such as the Capital Asset Pricing Model to design its calculations for these costs. Even so, this DCF model and the WACC calculations remain relatively simple and once the ratio or weighting is established, it can be used for all new projects and investments.
The WACC provides the minimum rate of return, or hurdle rate, to assess which projects to undertake. Along with this calculation, the DCF takes into account future values of other assets and equipment from forecasts and comes back with an estimation of how much an investment will cost and what its return will be.
The DCF model is a valuation technique that estimates the fair value of a business by discounting its future cash flows. This model is particularly well-suited for businesses with high growth potential, as it considers the time value of money.
2. The Three Statements Model
This model is perhaps the most common for startups and small businesses and is a perfect example of combining financial statements into a financial model. Typically, income statements, cash flow, and balance sheet data are used in forming this model and it is used to predict the position of the company as a whole.
This model is good for analyzing the historical success of a company and forecasting the conditions of the company based on these data. Typically, the first model sets the groundwork for future models and allows for more complexity in advanced models as more information is computed.
Designing the model starts with assumptions as the drivers. Assumptions can be margins, expenditures, and items from the balance sheet. Income statements and balance sheets are incorporated, and formulas driven by the assumptions lead to predicted outcomes in the model.
The 3-statements model can be as complicated or as simple as you like, and there are multiple courses and templates available to get started with this. Its strengths are in its flexibility, and ease of use in applications like Excel. Changing a value in a reference cell allows you to see the predicted outcome based on the data from your own financial statements.
This is basically a what-if analysis and is great for assessing best-case, worst-case and realistic scenarios and comparing the outcomes of the company’s financial position in the following years.
Here at ProjectioHub we have more than 50 different industry templates developed by our CPA that make creating these 3 statement model projections easy.
3. The Economic Value Added (EVA) Model
The EVA model is a valuation technique that estimates the economic value added by a company. This model considers the cost of capital, as well as the revenue and expenses associated with a company's operations.
The principle behind it is that value is only added to an investment when returns are generated above the rate of return to shareholders. Therefore, a project is only profitable when it earns a rate of return above its cost in capital. This is similar to ROI but it takes into account more costs for a more accurate value of returns and the benefit of exceeding expected gains.
As with the DCF model, EVA uses WACC formulae. Here though, they’re used to calculate the finance charge by multiplying the WACC by the capital invested. This value is then removed from the Net Operations Profits after Tax, to get the EVA.
Normally the cost of equity capital is ignored in accounting, but the EVA takes this into consideration, along with multiple other costs, making it a strong model
The criticism of this model is that it doesn’t manage profits in any way, and cannot guide asset holders in how to utilize profit effectively. It also cannot be used to project well into the future. Instead, it allows companies to assess whether an investment will generate value.
These three models are effective ways of predicting the financial outcomes of a company over different contexts. Each has its strengths and weaknesses and must be utilized deliberately in the correct application but all are common and popular methods for making financial plans in a business.
Each model is commonly used with deterministic inputs but with an advanced understanding of the complexities involved and model design, stochastic approaches to most are possible. Usually though, for the latter approach, it’s best to turn to expert help. And for that, there are plenty of options available.
An Easy Way to Create Financial Modeling Templates
ProjectionHub is a web-based platform that makes it easy to create financial modeling templates. It is designed for businesses of all sizes and offers a wide range of features, including the ability to share models with collaborators, access version history, and more.
With ProjectionHub’s library, you can access a wealth of pre-built financial models or build your own custom models. All templates are CPA prepared and compliant with Generally Accepted Accounting Principles (GAAP).
ProjectionHub is a great tool for startups and small businesses that want to save time and money on financial modeling.
Financial Forecasting Modeling - Final Thoughts
Financial forecasting is important because it allows you to make predictions about future financial performance. This can be the financial state of the company in five years, or simply whether the money that’s about to be invested will be effectively returned.
For long-term projections, models such as the three-statement model can be a great help by allowing present-day values to be tweaked in order to visualize the potential of their effects in the coming years. For an idea of whether an investment is healthy, the DCF model provides a baseline return needed to profit, and the EVA model gives a finely-calculated assessment of whether this is possible.
Each model has its applications, and some can be used in conjunction to increase their power, but all of these help you plan ahead in your business and make informed, strategic decisions about new products or changes in policy.