5 Things Every Financial Model Should Include

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Nearly anyone is capable of creating a financial model, but creating a good financial model that intakes the proper assumptions and is structured properly is no easy feat. There are many things to consider when preparing the financial model for your business that will direct the potential of success for your company. We encourage you to review this article in order to better understand what things to include in your financial model and how to structure it in a way that is easily communicated to third parties.

 

  1. Comparison Ratios

When it comes to forming financial projections, it is always a good idea to analyze your competition in order to form assumptions about the future. When performing this, remember to search for competitors that are of a comparable size and provide similar products or services.  A company that is vastly larger than yours, or sells a very different service is likely to not compare well when you are researching their financial performance. There are several tools that you can use in order to analyze the competition available on the market, since many companies keep their financial data very private. If the company is public, you can always use the EDGAR search database in order to review their most recent financial history.

 

  1. Conservative Estimates

Being conservative with financial forecasts is a must, but many companies avoid this fundamental strategy. If you are overly optimistic with forecasts, you will only be hurting yourself. Many investors will already be aware that you are being overly optimistic and discount your projections based on their own assumptions. The financial forecasts should be properly aligned with your competition, yet placing additional figures in the expenses and discounting your revenue, as forecasts vary rarely proceed as planned. While it is important to be conservative, you should also have bold objectives that are both reasonable and achievable and driven based on metrics you are analyzing.

 

  1. Explanation of Assumptions

Every strong financial statement includes a complete list of basic accounting assumptions, in addition to somewhat arbitrary decisions about the future performance of the company. For instance, the management team may be unrolling a new product within the fiscal year that is expected to increase overall revenue by 5 – 6%. This specific assumption should be clearly outlined in the financial statements and linking to the areas that it impacts. When preparing the financial model, a common mistake made is to assume that its review already has a background knowledge regarding the financial information, but everything should be clearly outlined so that they can understand how every figure was determined.

 

  1. Explanation of Assumptions

Every strong financial statement includes a complete list of basic accounting assumptions, in addition to somewhat arbitrary decisions about the future performance of the company. For instance, the management team may be unrolling a new product within the fiscal year that is expected to increase overall revenue by 5 – 6%. This specific assumption should be clearly outlined in the financial statements and linking to the areas that it impacts. When preparing the financial model, a common mistake made is to assume that its review already has a background knowledge regarding the financial information, but everything should be clearly outlined so that they can understand how every figure was determined.

 

  • Growth Assumptions: The growth assumptions about the company should be clearly outlined if you do not extrapolate the company’s historical growth rate identical to past performance. For instance, forecasting an increase in sales of 10% should be justified by research and supporting analysis materials that will help your company to justify such an increase.

 

  • Risk Assumptions: The risk assumptions about your performance should also be outlined in order to be more conservative. This includes communicating the restrictions that may inhibit or restrict the potential to reach the targets set forth in the financial model. Examples of such risks may include the risk that new competitors will enter the market if you are the first to

 

  • Management Discussion & Analysis: Most investment statements are accompanied with a discussion of key points from the management team. This applies to financial projections by outlining the company’s future strategy and how it integrates with the financial model. Since some information is referenced from management, it is better to have first-hand information rather than rephrasing them or summarizing information, as it is subject to err.

 

  • Competitors Used for Analysis: The competitors used in the analysis should be communicated within the financial model or the source. If you are using industry financial ratios, then you should list the source or how the information was compiled. In a best case scenario, you will provide the specific company used during analysis, but industry specific ratios are better than using no basis at all.

 

  1. Scenario Analysis

Aside from a basic forecast, most reviewers of your financial statements will want to see how it will perform under various probable conditions. This means identifying how key factors will impact your company if certain circumstances take place. For instance, the continued price decline of an oil fields services provider at various price per barrels or the coffee price for a wholesale importer of coffee supplies. The scenario analysis is performed over multiple iterations in order to provide the reviewer with a worst to best case interpretation and how it impacts your bottom-line valuation.

 

We hope that this article has provided you with a greater degree of understanding for the implementation of your financial model. While no model is perfect, including some critical factors is likely to improve the accuracy and understanding when being reviewed by third parties. For more information about financial reporting, this article on the key financial statements will provide you with information about what to include and how to structure it.