Introduction
A bottom-up financial model is an analysis tool used to evaluate an individual company's financial potential. The model uses the company's financial statements, such as its income statement, balance sheet, and cash flow statements, in order to create an operational forecast. It is specifically designed to assess the future profitability and risk associated with a company.
When using a bottom-up financial model, it is important to consider potential risks that may impact the company's operations and performance. Common risks that should be accounted for include:
- Market Risks
- Industry Risks
- Financial Risks
- Organizational Risks
Key Takeaways
- Understand the bottom-up financial modeling approach
- Evaluate a company's financial potential
- Consider potential risks that may impact operations and performance
- Account for market, industry, financial, and organizational risks
Correlating risks
When building a bottom-up financial model, it is important to incorporate various risks associated with different markets. Risk correlation exists between money markets, equity markets, and fixed-income markets. It is important to understand how market fluctuations and other external factors may have different impacts on the models.
Money Market Risk
Money market risk is the risk associated with financial instruments that are issued for a short term, typically less than a year. These instruments include government securities, treasury bills, certificates of deposit, and commercial paper. Since money market instruments fluctuate, they may incur certain risks. In a bottom-up financial model, it is important to analyze money market risk and how fluctuations may affect the model.
Equity Risk
Equity risk is the risk associated with investments in stocks, mutual funds, and other equity-based securities. This type of risk is typically higher as compared to other markets, such as the money market. When building a bottom-up financial model, it is important to analyze the risk associated with equity markets and how these can impact the model.
Fixed-Income Risk
Fixed-income risk is the risk associated with investments in bonds and other debt securities. This risk is typically lower than equity risk but may be affected by factors such as changes in interest rate and inflation. As with equity markets and money markets, it is important to take into account fixed-income risk when building and assessing a bottom-up financial model.
Credit Risk
When building a "bottom-up" financial model, credit risk should be one of the most important factors taken into account. Credit risk is the risk of loss due to a borrower defaulting on their payments. It is important to understand how the company's capital structure and lending policies might affect its potential credit risk.
Capital Structure of Borrowings
The capital structure of a company is the proportions of its debt and equity held in its financing mix. A company can issue many types of borrowings, including senior secured debt, subordinated debt, asset-based loans, and more. Understanding the company’s debt composition, as well as its overall credit risk profile and financing costs, is key for assessing its credit risk.
Lending Policies
Apart from the structure of borrowings, a company's lending policies are also important to think about. Companies usually have certain criteria they must meet before they can borrow. This often includes things like loan covenants, prepayment restrictions, and other conditions. Understanding these policies and how they might affect the company’s ability to meet its debt obligations is essential for assessing credit risk.
Market Risk
Market risk involves the possible losses due to changes in the prices of financial instruments such as stocks, bonds, and currencies.In a bottom-up financial model, it is important to account for market risks that could potentially impact the project’s returns. These risks are largely divided into three categories – interest rate risk, exchange rate risk and commodity price risk.
Interest Rate Risk
Interest rate risk is the risk of adverse changes in fee or interest as a result of changes in the overall level of interest rates in the economy. This risk is especially relevant when the project involves taking out loans to finance the capital expenditure. In that case, if the interest rates increase, the project may see increasing cash outflow in the form of loan repayments. Such an increase in cash outflows, if not accounted for, can have a significant impact on the project’s returns.
Exchange Rate Risk
Exchange rate risk is an important consideration in a bottom-up financial model when the project involves activities across different currencies. If the foreign currency depreciates significantly against the base currency of the business, it could lead to a drastic increase in cost of capital, as the repayment of foreign debt will be more onerous.
Commodity Price Risk
Commodity price risk is the risk arising from changes in the price of the commodities used in a project. In a bottom-up financial model, it is important to include an allowance for such changes as it can have a significant impact on the cost of production.
When assessing the market risks, businesses can use hedging strategies such as derivatives, forward contracts, options and futures. These contracts are designed to help protect against unfavorable changes in the prices of the underlying assets. They can be an effective tool for mitigating market risks provided that the business has an accurate assessment of such risks.
Operational Risks
Operational risks encompass the human and device errors, compliance with regulations and systemic failures which can influence a financial model. A successful bottom-up financial plan should recognize potential operational risks, and plan for their outcomes.
Human Error
Even with the best intentions and an abundance of experience, human error can never be completely eliminated. It is critical to include a budget to account for these mistakes. This budget must be mindful to not include any more average than necessary.
Regulatory Compliance
A financial model must factor in the costs associated with regulatory compliance. Laws and regulations can burden a budget if not properly accounted for in the planning stages. Compliance costs should be considered and proper estimates made according to the region in which the model will be implemented.
Systemic Failure
Though unlikely, systemic failure does occur. Instances of malware, power-outages, and other computer-based or software related problems can significantly affect a financial model. To protect against these risks, a budget item should be allocated to a system control reserve.
- This could be placed in an emergency fund, to provide financial protection should a system issue arise.
- It can also be used to pay for additional personnel or IT expertise that may be needed to respond to such an issue.
Strategic Risks
Risk management is an important aspect of any financial model. It is essential to account for any potential risks that could arise, in both the immediate and long-term, when it comes to investments. It is critical to remember that these risks can come from a number of different sources, including both internal and external factors. In this section, we will look at two of the most common types of strategic risk, namely competition and macroeconomic environment.
Competition
Competition is a major source of strategic risk that needs to be accounted for when creating a financial model. It is essential to understand how competitive the market is and how competitive any upcoming investments may be. Companies must be aware of the competitive landscape and account for any potential risks that may arise as a result. For example, if a company is planning on entering a new market, they need to understand the other competitors that exist within that space and account for any risks associated with entering a market that may already be crowded.
Macroeconomic Environment
The macro economic environment is another key source of strategic risk and should be taken into consideration when forming a financial model. Macroeconomic environment refers to the larger economic conditions that can affect a company, such as inflation rate, foreign exchange rate and interest rate. Companies must be aware of any potential risks associated with these conditions and account for them in their financial model. For example, if a company is operating in a country with high inflation, they should account for the potential risks associated with that when consolidating their financial statement.
It is important to remember that strategic risks can come from a variety of different sources. Companies must be aware of the potential risks associated with the competition they face and the macroeconomic environment they operate within when creating a financial model. By accounting for potential strategic risks in their model, companies can reduce the overall risks associated with their investments.
Conclusion
The use of a bottom-up financial model is essential in creating an accurate financial outlook for businesses. Knowing when to account for risks, as well as which risks to consider have become essential knowledge for decision makers. Accounting for risks not only allows decision makers to become aware of potential losses, but also allows them to plan accordingly.
Risk management strategies should include the steps of identifying, analyzing, monitoring and mitigating the different levels of risk that can be encountered in the bottom-up financial model. Knowing the different sources that may introduce risks and evaluating the factors that may cause them will provide an informed and accurate outlook for making informed decisions. Furthermore, businesses should regularly monitor and review the risks that have been accounted for in the bottom-up model to ensure that changes in the landscape are reflected in the model.
Through the implementation of proper risk management strategies, businesses can succeed in accounting for risk in their bottom-up financial model. This will provide the decisiom makers with valuable information that will assist them in making informed decisions for their businesses.