Understanding the Importance of Financial Modeling: Should You Build a 3-Year Model?
by CFO Selections Team, on Jul 6, 2023
A financial model is a type of financial projection that pulls together important data to allow organizations to analyze their current financial position and predict their future financial position. While effective financial modeling takes significant time and expertise to complete, the considerable benefits provided make it well worth the investment. Financial modeling is an essential tool used to manage risk, allocate resources, make smart investments, secure funding, and develop long-term growth strategies. Some projections are over a longer time horizon while others only cover a short time horizon. However, whether your financial model covers two, three, five, or ten years, it’s important to understand what it should accomplish, why you should do one, and what it should include. Find out now why you need financial modeling and how to build a financial model for your organization that will offer the insights needed to make key strategic decisions. In these economically tumultuous and uncertain times it is no longer optional for companies to delay or forgo financial modeling. The complexities of today’s business environment require that organizations be more proactive with their planning than ever before. Accurate financial modeling provides the information that organizations rely on to thrive, as well as benefits across: Risk Management Financial modeling is a key component of conducting a risk assessment. By knowing what revenue and expense projections look like in the near future, organizations can better identify and mitigate risk both today and tomorrow.
“How do you build a three-year financial model?” It’s a question we get (and answer) a lot.Why is Financial Modeling Important?
Capital Allocation
Financial forecasting also informs capital-related decisions related to allocating existing resources, prioritizing projects, and timing major purchases to maximize value and maintain positive cash flow. The result is smoother day-to-day management of the company and more sustainable long-term growth.
Growth Strategy
While the goal of financial modeling is to predict what may be coming next, it can also shed significant light on how financially stable a business is currently. As a result, a financial model is not only a forecasting tool, but also a measuring stick to assess a company’s current performance. Armed with this information, business leadership can analyze how the organization is performing relative to its current goals and expectations as well as develop a plan for future growth.
Funding
Securing funding to drive business growth relies on having timely business forecasting and modeling to provide to investors and lenders. Financial modeling gives potential investors and stakeholders the information they want to see to determine whether they will fund a business, and what kind of terms they will require to do so.
Business Value
Additionally, business modeling not only aids in making a business valuation calculation for owners looking to sell their company, but can also strategically increase business value for owners looking to hold onto the company indefinitely. Regardless of who owns it, the roadmap that emerges from financial modeling will benefit the organization into the future.
How to Build a 3-Year Financial Model
Now that you know why financial modeling is important for business leadership, let’s take a look at how to create a 3-year financial forecast.
- State the Objective
It may sound odd to say that the starting point in building a financial model is determining what the purpose of your financial model will be, but it is a crucial first step. Some financial models are meant to be used for strategic decision-making, while others are geared towards fundraising initiatives. Know what you want to accomplish before getting started.
- Clarify Financial Assumptions
State and define the assumptions you are basing the financial model on to give it context. Use historical data, industry benchmarks, current market research, and other reliable sources to set your assumptions. Clearly present these assumptions to give the model validity in the eyes of anyone reviewing it.
- Make Revenue Projections
Forecast revenue figures using historical data, seasonal fluctuations, current growth rates, and industry analyses. Adjust based on current market trends as often as needed to maintain realistic ongoing revenue projections.
- Estimate Operating Expenses
Examine current fixed and variable expenses as well as projected future expenses to understand what may be coming next. Where expenses are trending upward, pay especially close attention to these shifts to forecast what expenses may look like over the time horizon of your financial model.
- Include Capital Expenditures
For upcoming investments in capital items like equipment, technology, and infrastructure understand when these expenses will be incurred and what the impact will be on your financial model. If the timing of these expenditures is flexible, determine what delaying or expediting these expenses would do to your projections to inform timing-related decision-making.
- Evaluate Financing Options
Use financial modeling to determine which mix of financing is going to be the most advantageous to your organization weighing the costs and risk of different options like equity and debt financing.
- Prepare Cash Flow Statements
Use the company’s projected income statement and balance sheet to generate a projected cash flow statement. Look for cash flow trends to help ensure that the company has sufficient cash on hand to meet short-term financial obligations and set aside for longer-term investments.
- Determine Financial Ratios
Calculate key financial ratios like profit margin, gross margin, quick ratio, debt-to-equity ratio, working capital ratio, inventory turnover, return on equity, and return on assets. Lean on these ratios to gain additional insight into the organization’s financial health and better inform your financial projections.
- Conduct Sensitivity Analysis
Gauge the sensitivity of your working financial model by changing the underlying assumptions. Use worst-case scenario conditions to stress-test the model and better understand key revenue and profitability drivers.
- Utilize Scenario Planning
Create multiple financial models based on your sensitivity analysis to understand what projections would look like across numerous scenarios. Use the range of resulting outcomes to better assess possible future outcomes.
If the process we have described to create a three-year model sounds daunting, we are here to help! When you need strong financial leadership, count on our team of experienced consulting CFOs. We have the fractional financial leadership options to come alongside your company no matter which stage of business it is in currently. We understand the many types of growth trajectories that organizations can take as they evolve and can assist with financial modeling to reflect your company’s unique circ*mstances.
Related posts
When to Use a ‘Decision Tree’ for Business Planning
What to do When You Don't Know What to do – A CFO's Perspective
Getting your Financial House in Order Before Selling Your Business
Danger Ahead – What are the Future Business Risks? And what can we do about it? (From a CFO’s Perspective)
Topics: Finance, Trends, Planning, Financial Projections, Risk Management
Topics: Finance Trends Planning Financial Projections Risk Management
