Why you’re here and what you’ll learn.
If you’re like most business owners, you understand the importance of financial forecasting but don’t have the time or resources to build a model yourself.
That’s where we come in.
In this article, we’ll walk you through step-by-step how to build a financial forecast model for your business.
We’ll explain the different elements and technicalities of financial forecasting so that you can understand what goes into a good model, why it’s important and what the best tools currently are on the market to help you automate as much of this process as possible.
Financial forecasting is essential for all businesses – don’t leave your project up to chance, follow our guide on how to build a financial forecast model today!
Why take our word for it?
With over Two Billion Pounds of property investment managed under our belt, we understand that the financial performance of a project directly contributes to the bottom line of the business. Financial models safeguard against risk maximising opportunities and account for externalities that could impact the success of a development and are the backbone of any successful financial planning.
What is a financial model and financial forecast modelling?
A Financial model is a mathematical model that represents the financial decision-making required throughout a project or development. Financial forecasting is the process of creating such a model. The purpose of the model is to forecast future outcomes so that appropriate decisions can be made about how to allocate resources today.
The inputs into the model are variables that can be measured and quantified such as the amount of money to be invested, the expected rate of return, the length of time of the investment and so forth.
The outputs of the model are also variables that can be measured such as net present value, internal rate of return and payback period.
Why financial modelling is critical for a business and project.
Financial modelling is critical for a business or project because it provides a framework within which to make key decisions. The model allows you to test different scenarios so that you can see the impact of changes in assumptions on the outcome of the project.
For example, you might want to know what would happen if you increase your marketing budget by 20%. The financial model would quickly show you the impact on profits and returns.
Financial modelling is also critical for a business or project because it provides transparency. All of the assumptions that go into the model are laid out in an easy-to-understand format so that anyone can see how the outcome was arrived at and that all variables and risk have been accounted for.
This is important for two reasons: first, it allows you to get buy-in from key stakeholders on the assumptions that are being used. Second, it provides a level of assurance that the outcome of the project is robust and has been thought through.
Types of financial model
Top Down
The top-down approach starts with a big picture in mind and works its way down. For example, if you’re starting with a project budget of £100 million – by year 2 of project completion (when the development is stabilised) the model will take into account the variables on a high level to display there could potentially exist X% return on initial investment annually. This allows a business to know what’s financially possible before they even start spending any real money or time on making it happen.
Bottom Up
The bottom-up approach is usually the preferred method for development projects as it is more detailed and starts with the basics. The business starts with basic assumptions such as land value and anticipated build cost and then creates scenarios that change these numbers to see how it impacts our goals – for instance, if there are too few homes on offer or the programme takes too long to recoup investment then a business can adapt the key metrics within the forecast until the model and investment strategy matches the risk the business is willing to take.
Getting started and the fundamentals
Assumptions
This should be the first tab in a spreadsheet and contain variables that will be used in the other tabs. Ideally, the rest of the tabs should have no manual input and every single number will be sourced and calculated from the assumptions tab.
The assumptions used will be unique to a business and the specific project they are working through. the first step will be to make a list of all the assumptions that you will need to make to generate your financial forecast. These could be things like:
- The expected rate of return on investment
- The length of time of the investment
- The amount of money to be invested upfront
- Hard costs
- Municipal fees
- Legal fees
- Tax
The more detail you can provide the greater the strength of your model and the more certainty on outputs you can rely on.
Once you have a list of all the assumptions, you need to quantify them. This means assigning a numeric value to each assumption. For example, if one of your assumptions is that the expected rate of return on investment is 20%, then you would assign the value 20% to that assumption.
If you are not sure what value to assign to an assumption, you can use a range. For example, if you are not sure what the expected rate of return on investment will be, you could assign a range of values such as 15% to 25%.
Once you have quantified your assumptions, you need to input them into the model. This is usually done in a separate sheet from the rest of the model so that it is clear which assumptions are being used.
Make sure that you label each assumption clearly so that anyone looking at the model knows what it is and where it came from.
Income statement
The income statement is one of the most important aspects of the financial model. In simple terms, It shows a company’s revenue and expenses over a period of time. The income statement can be prepared for any length of time but is usually done over the lifecycle of a project.
The income statement has three parts:
- Revenue: This is the amount of money that a company has earned from its main activities.
- Expenses: This is the amount of money that a company has spent on its main activities.
- Profit (or loss): This is the difference between revenue and expenses.
The income statement is important because it shows whether a company is making or losing money. It is also used to calculate other financial ratios, such as the profit margin and the operating margin.
To create an income statement, you will need to gather data on your revenue and expenses. This data can be sourced from your accounting software, your total project costs, or your tax returns.
Once you have this data, you will need to input it into the model. The income statement is usually presented as a table with revenue and expenses on the left side and profit (or loss) on the right side.
Make sure that you label each section of the income statement clearly so that anyone looking at the model knows what it is and where the data came from.
Balance sheet
The balance sheet is a snapshot of the business’ assets, equity, and liabilities. It is an indicator of the financial health of the company, showing what it owns and owes.
The balance sheet has three parts:
- Assets: This is everything that a company owns.
- Liabilities: This is everything that a company owes.
- Equity: This is the difference between assets and liabilities.
The balance sheet is important because it shows the financial health of a company. A company with more assets than liabilities is said to be “asset-rich” and is in a strong financial position.
To create a balance sheet, you will need to gather data on your assets and liabilities.
Cashflow statement
The cash flow statement shows how much cash a company will be required to put through a project. It is a vital part of the financial model as it shows whether a company is generating enough cash to cover its expenses.
The cash flow statement has three parts:
- Operating activities: This is the cash that a company generates from its main activities.
- Investing activities: This is the cash that a company spends on its investments.
- Financing activities: This is the cash that a company raises from investors and lenders.
To create a cash flow statement, you will need to gather data on your project operating activities, investing activities, and financing activities. This data can be sourced from various sources throughout your business or can be provided by a third-party specialist to provide estimations.
Project/ Business valuation and Sensitivity analysis
After you have completed your financial model, you will need to do a valuation to see how much your project or business is worth. This can be done using several methods, such as the discounted cash flow method or the comparable projects method.
A sensitivity analysis can be defined as a tool used to determine how different factors will affect a project. For example, you can use a sensitivity analysis to see how changes in development metrics will affect your project’s key returns.
Once you have completed your valuation and sensitivity analysis, you will have a good understanding of the financial health of your project and how it could be impacted by changes in the market.
KPI Overview
The outputs when financial modeling typically also include some company and/or sector-specific KPIs (key performance indicators). As the name already implies KPIs are crucial metrics for your project to display to potential investors.
KPIs do not only matter for an investor, but also for your project. Based on these metrics you track the performance of your company, experiment with different acquisition channels, business models and cost structures, and use them to make you and your co-funders laser-focused on the targets you defined.
There are KPIs that show returns and profitability performance (such as revenue growth rate, gross margin, or profits), KPIs related to cash flow and raising investment and company or industry-specific KPIs.
Inputs
Below we have listed five common elements that typically serve as the input sheets when financial modeling.
Financing
In this sheet, you would add financing streams such as equity, loans or subsidies. The main goal of this would be to check the impact on your funding need when you add different types of funding in different years of the model.
You can also use this sheet to evaluate different financing options and their trade-offs. For example, you could compare the terms of different loans or equity investments and see how they would impact your business.
Investments in assets (capital expenditures)
This sheet is used to track investments in assets such as land and materials. The main goal of this sheet is to see the impact of these investments on your cash flow and profitability.
You can also use this sheet to evaluate different investment options and their trade-offs. For example, you could compare the cost of different land purchase timing structures and see how they would impact your business.
Costs
This sheet is used to track all the costs associated with your project. The main goal of this sheet is to see the impact of these costs on your cash flow and profitability.
You can also use this sheet to evaluate different cost-saving options and their trade-offs. For example, you could compare the cost of different materials and see how they would impact your business.
Although this element seems straight forward it must be noted that a detailed review of all potential costs ae included so there is no unforeseen risk.
Operational Expenditure
Operating expenses are those expenses that a business incurs as a result of performing its normal business operations. Unlike the cost of goods sold, they are not necessarily needed to produce the goods that are sold or to deliver the services promised. They include costs related to the supporting and operational side of the business, such as sales and marketing, research and development and general and administrative tasks.
Revenue
The revenue is the top line of your financial modeling and it shows the total income that your project generates. The main goal of this sheet is to see the impact of different revenue streams on your cash flow and profitability.
You can also use this sheet to evaluate different pricing options and their trade-offs. For example, you could compare the price of different products and see how they would impact your business.
This is one of the most important inputs into a financial model as it will have a direct impact on the profitability of your project.
Additional elements
Tax
This sheet is used to track the taxes that your project will incur. The main goal of this sheet is to see the impact of these taxes on your cash flow and profitability.
You can also use this sheet to evaluate different tax-saving options and their trade-offs. For example, you could compare the tax implications of different business structures and see how they would impact your business.
Inflation
This sheet is used to track the inflation that your project will experience. The main goal of this sheet is to see the impact of inflation on your cash flow and profitability.
You can also use this sheet to evaluate different inflation-hedging options and their trade-offs. For example, you could compare the cost of different materials and see how they would impact your business.
Working capital
This sheet is used to track the working capital that your project will need. The main goal of this sheet is to see the impact of working capital on your cash flow and profitability. You can also use this sheet to evaluate different working capital options and their trade-offs. For example, you could compare the cost of different inventory options and see how they would impact your business.
Conclusion and round up
Financial forecasting is a tool that can be used to track the financial performance of a business project. It is important to understand the different elements of a financial forecast model so that you can make sense of the outcomes.
This article has provided a step-by-step guide on how to build a financial forecast model. By following this guide, you can set your next project up with the strongest financial foundation possible.
Do you have any tips on how to build a financial forecast model? Share them in the comments below!