5 Principles of Financial Modeling

Our article provides you with a five-step guide to financial modeling for freelancers and independent professionals. First, clarity, objectives, and framework conditions must be defined. Second, transparency is essential to make assumptions traceable and understandable. Third, flexibility is needed to adapt the model to different scenarios. Fourth, precise use of reliable data. Fifth, documentation to record the process. These principles help you make well-informed financial decisions.

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What is Financial Modeling?

Financial modeling is an excellent tool for forecasting the future economic development of a company. It is fundamental to a well-developed business plan. It helps make investment decisions, plan resources, mitigate risks, and ultimately achieve better business results. In financial modeling, either a model is created from scratch or an existing model is maintained through the implementation of newly available data.

With these 5 principles of financial modeling for startups and SMEs, you will understand the fundamentals of forecast models, learn a holistic perspective, and recognize the interdependencies of various topics.

Application of Financial Modeling

The principles of financial modeling find application in various sectors. The term “financial modeling” is heard most frequently in the world of investment banking.

In investment banking, it is used to predict the potential financial performance of a company in the future by making relevant assumptions about how the company or a specific project is likely to develop.

For example, it is used to determine how much cash flow a project will generate within five years of its launch.

However, financial modeling is no longer limited to investment banking. For startups, SMEs, and large enterprises, it plays a decisive role in planning future development and convincing potential investors.

Here is a list of areas that can benefit from financial modeling:

• Investment planning and financing
• Feasibility studies
• Cost-benefit analysis
• Risk management
• Business planning, budgeting, and forecasting
• Company valuation
• Lifecycle cost analysis
• Strategic scenario planning
• Project financing and financial planning in enterprises

As you can see, financial modeling can be very useful for various areas.

1. Preparation

At the beginning, it is important to determine what the forecast model will be used for. This is directly related to granularity. The more detailed a model must be, the greater the risk of errors and incorrect assumptions. Another important determinant for structuring a model is its required flexibility. Flexibility depends on how often the model is used, by how many users, and for how many different purposes. A model developed for a specific transaction or company requires far less flexibility than a model designed for frequent reuse (often referred to as a template).

Furthermore, the following questions are of essential importance:

• What is the goal of financial modeling?
• What must the financial model accomplish?
• How and by whom should it be used?
• What time, personnel, and financial resources, etc., are available?

“If you fail to prepare, you are preparing to fail.” – Benjamin Franklin

To create a good financial model, you must also choose the right tool and set a specific goal. The best tool for planning remains MS Excel, which is used by investment banks and large enterprises alike for financial modeling. Color coding for cells, column consistency (uniform time axis), and row consistency (one formula per row) must be implemented from the start to avoid time-consuming rework.

2. Financial Modeling Standards

The effort you put into financial modeling is only worthwhile if it can be easily used and understood by others. Color coding, font size, formatting, and naming are part of the presentation. This may sound simple, but the interplay of all these factors makes a significant difference in how the model looks.

The most commonly used colors are blue for any constants used in the model, black for all formulas, and green for cross-references from different sheets.

Logical integrity is of paramount importance. Since the author of the model may change, the structure should be strict and integrity should come first. The financial model should be based on formulas that can be easily understood by other financial modelers and non-modelers alike. It should be flexible and adaptable in any situation, as the unexpected is a natural part of every business or industry.

The flexibility of a financial model depends on how easy it is to modify the model whenever and wherever necessary.

3. Fundamentals of Financial Modeling: Strategic Scenario Planning

As part of strategic business planning, various scenarios are usually developed and tested. Each scenario presents different opportunities and risks. Mapping these options requires advanced financial modeling. The tricky part is estimating the numbers, followed by financial modeling in combination with simulations and evaluation of the possibilities.

Tip: To estimate the numbers as accurately as possible, you should consider historical data, quotes, and competitor analysis.

A simple example would be estimating expected revenue for a fitness app. There are various methods, but the most common are top-down and bottom-up.

What is Top-Down Financial Modeling?

A top-down revenue estimate is based on looking at the total market and estimating the market share your company can achieve. Our market research might show that people in our target city spend 100 million dollars on fitness and nutritional supplements. If we achieve a 5% market share, we can expect approximately $5,000,000 per year.

The advantages are that it is quick and easy when you have the right data. A good information source is Statista. The disadvantage is that it is not very accurate and can lead to overly optimistic estimates. If your foundation is wrong, then the assumptions for the targeted “market share” are also not valid.

What is Bottom-Up Financial Modeling?

In the bottom-up approach, you build your estimates for your financial model from the smallest units. The advantage is that you must think carefully about how your business will make money and what expenses will be incurred. The disadvantage is that it can be time-consuming to create a detailed financial model because you are adding many revenue and expense items.

Financial modeling is both simple and complex. The key is to prepare smaller modules and connect them together to create the final financial model.

4. Lifecycle Cost Accounting

Lifecycle cost accounting is a method for evaluating investment alternatives by considering the total cost of an asset during its lifespan. The most common mistake we observe in our clients’ financial modeling is that too much attention is paid to initial investment costs and too little to future operating and maintenance costs. This makes sense, as it is often difficult to compare purchase versus lease alternatives.

The Solution: With the principles of financial modeling, you can determine the cash flows over the entire lifespan of an asset. The most reliable way to compare costs between alternative solutions is to estimate all costs (cash outflows) over the entire lifecycle and then discount the cash flows of the alternatives.

An important goal of lifecycle cost accounting is to influence later and recurring costs. This is done by identifying and evaluating trade-offs between initial and subsequent costs. Higher initial costs can justify lower follow-on costs. For example, manufacturing costs increase when using environmentally friendly materials, but disposal costs can decrease many times over in the end. Therefore, it is important to capture all costs associated with deployment in detail.

Let’s take another look at our beloved fitness app. A variety of costs influence the app’s lifecycle costs beyond the initial development costs. These include, among others:

• Functional services (e.g., push notifications)
• Administrative services (updates, user management)
• Infrastructure services (servers, CDN)
• IT support (updates, bug fixes, etc.)

5. How to Write Good (and Simple) Formulas

When working with Excel, the temptation to create complicated formulas is great. It may feel good to develop a complex procedure, but the downside is that no one will understand it – and you as the author will likely have difficulty following it after a while.

The “Keep It Simple, Stupid” (KISS) approach also applies to financial modeling. Nobody likes unnecessarily complicated things. Clear structure and transparency are critical. Our advice: To achieve simplicity, you can often break the detailed procedure into several cells and simplify it. Remember, Microsoft does not charge extra for using multiple cells! Take advantage of that.

Common Pitfalls in Financial Modeling

An essential formula in financial modeling is the calculation of cash flow. Cash flow provides information about the earning power and financial strength of a company and is of great importance to lenders, potential investors, and shareholders.

To make this statement, all items must be removed from net income that have no monetary value because they flow in or out of the amount without an actual economic value being received or spent. This includes, for example, depreciation and provisions.

Two main methods can be used for cash flow calculations: the direct and the indirect method. The indirect method is common for larger companies.

Indirect Cash Flow Calculation

To determine (gross) cash flow indirectly, non-cash items are eliminated from net income. The basic formula for the indirect calculation of cash flow is:

Net income − non-cash income + non-cash expenses = Cash flow in the narrower sense.

Non-cash expenses may include:

• Allocations to reserves
• Increase in retained earnings
• Depreciation
• Increase in special items with reserve component
• Increase in provisions
• Decrease in inventory of finished and unfinished goods
• Non-period expenses and extraordinary expenses

Non-cash income includes, among others:

• Withdrawals from reserves
• Reduction of retained earnings
• Appreciations
• Reversal of impairments
• Reduction of one-time items with equity component
• Reversal of provisions
• Increase in inventory of finished and unfinished goods
• Activated own services
• Non-period income and extraordinary income

Conclusion

The fundamentals of financial modeling are indispensable for creating integrated business planning (forward-looking) in order to obtain a transparent picture of a company. With good planning and structuring, even beginners can model various scenarios and their associated risks.

To convince potential investors, accurate figures and logical assumptions are of paramount importance. Your financial model must be easy to understand and clear. Above all, it must convincingly present your business case.

This is precisely where you should seek advice from an expert. Feel free to contact us for a free consultation. We will find the best way to support you and your business.

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