Designing a robust bottom-up financial model is essential for good decision making in finance. It becomes increasingly important for any business to make well-informed predictions about the expected cashflows, profits and losses for the future. A good financial model helps a business create the necessary foundations for sustainable growth and success, by enabling it to plan for the best- and worst-case scenarios.
The difference between a top-down and a bottom-up model lies in the approach. In a top-down approach, an overall goal is defined and the model is designed to identify how to reach that goal. On the other hand, a bottom-up approach requires an analysis of the components of the goal and modeling how these components can come together to reach an overall goal.
- Distinguish between the approach of a top-down and bottom-up model
- Understand the importance of a good financial model for sustainable business growth
- Gain insights on making well-informed predictions about future cash flows and profits
Creating an Operating Model
Creating an operating model is a key step in the design of a strong bottom-up financial model. It is critical to understand the operational processes and the components that comprise the model, as well as the total costs associated with each part. A robust operating model provides the foundation for an effective financial model that can help predict, analyze and present future scenarios.
The importance of understanding the operational processes
The operating model should be designed to accurately represent the organization and its operations. The underlying purpose of the model is to incorporate all aspects and variables of the organization including revenue, costs, and growth drivers. Understanding the operational processes and the drivers of your organization is an essential step in creating a reliable operating model.
The technical competence of the modeler is important for designin an accurate operating model. This includes data gathering and estimation of the drivers of operations. The modeler should understand the industry and relevant financials of the markets and the organization. This ensures that the outputs of the model will reflect reality more accurately. Understanding the operational processes is the foundation for a reliable model.
Defining the components and estimating the costs
The components and costs of an operating model should all be carefully defined and estimated. This ensures that the model output will be accurate and reflect reality. A number of elements should be considered including materials, labor and other costs, such as facilities and administrative costs. The cost estimation should be based on data gathered from the organization and the industry, as well as qualitative information. Estimations should be conservative, taking into account potential risks, fluctuations in the market, or changes in the organization.
Estimating the costs accurately can ensure that the operating model is reliable and effective. The cost estimates should be based on data gathered from the organization and the industry. A successful operating model should accurately reflect the company’s operations and provide reliable estimates of the costs associated with each process.
Estimating the Revenues
The estimation of revenues is one of the most important steps in designing a robust bottom-up financial model. Estimating the total revenues of a business requires an understanding of the sources of income as well as the various components of each income source.
Understanding the Sources of Income
Revenues for a business can come from a variety of sources, including sales of products and services, fees from clients, and grants or investments from other parties. To understand the sources of income, businesses must first look at their business model to see how they generate revenue. Businesses can then assess each of these income sources to ascertain their total contribution to the business’s total revenue.
For example, a business may generate revenue through the sale of products or services. To understand the contribution of these sales to total revenue, the business should consider factors such as the number of units sold, the price of each unit, the cost of producing or delivering the product or service, and the associated marketing and distribution costs.
Determining the Total Revenue
Once businesses have a better understanding of the sources of income, they can then assess each income stream to calculate the total revenue. This calculation should be done by taking into account the total amount earned from each source as well as any applicable taxes, discounts, or other deductions that could affect total revenue.
In addition, businesses should also consider any potential discounts they may be able to provide to incentivize customers to purchase their products or services and any potential opportunities to maximize their revenues, such as pursuing new partnerships or engaging in promotional activity.
Estimating the Expenses
Estimating the expenses that form part of a robust bottom-up financial model is one of the most important steps in the process. These expenses form the basis of the financial projections, and so it is of utmost importance that they are estimated as accurately as possible. Accurate estimates of cost of goods sold and operating expenses will provide an accurate projection of the overall financial performance of a business.
Estimating the cost of goods sold
Estimating the cost of goods sold (COGS) is an important factor in the overall financial projection. The most accurate way of estimating the COGS is to provide an estimate for each individual good in the company's inventory. When looking at each product, it is also necessary to include in the estimation any raw materials and manufacturing costs that will be associated with each product.
Estimating operating expenses
Estimating the operating expenses for a company is an important step in the development of the financial model. It is important to include in the estimation any costs that are likely to be incurred as part of normal operating activities such as employee wages, rent and utilities, marketing and advertising costs, and any other costs that are likely to be incurred as part of the day-to-day operations of the business.
Any additional costs that may be associated with special projects or one-off consulting services should also be included in the estimation of the operating expenses. Additionally, estimates should also take into consideration any changes that are expected over time, such as increases or decreases in the cost of raw materials or increases in employee wages.
Modeling Financial Statements
Financial forecasting models are invaluable tools in assessing the health of a business. Rather than relying on historical data, bottom-up models are designed to assess the current financial state of a company and predict future performance taking into account key variables. While robust financial models are usually complex, they can serve as invaluable resources when estimating the financial output of a business.
Outlining the various inputs and outputs
The complexity of a bottom-up model is largely dependent on the number of variables being taken into account. However, key inputs typically include revenue, expenses (cost of goods sold, operating costs, and taxes), assets, liabilities, and equity. Outputs, on the other hand, include net income, cash flow, and asset turnover.
Understanding the financial implications of each input
Having an understanding of the financial implications of each input is an essential step in creating a robust financial model. For example, consider the impact of changing the value of one of the key inputs - revenue. A higher value results in increased net income and cash flow, however, unless there is a corresponding lower value for one of the expenses, this increase won't be as beneficial.
Therefore, in order to assess the financial position of a business, it is important to understand the impact of each key input, so that they can be adjusted accordingly in order to accurately estimate performance.
Stress Testing the Model
Stress testing the developed financial model is an essential step to ensure it can properly handle changes in both the external and internal environment. All credit, market and liquidity risks should be stress tested to identify potential risks and refine any assumptions used in the modelling process.
Refining the Assumptions & Identifying Potential Risks
The modelled results should be closely evaluated against those from the actual financials to identify any potential risks, such as operational risk, interest rates, foreign exchange rates and other market-related risks. To accurately assess the potential risks, any assumptions must be revisited and any discrepancies adjusted accordingly.
For example, when assessing the potential impact of rising interest rates, a sensitivity analysis can be used to test the results of various scenarios. This could take the form of an assumption that key rate operates at various levels in the future and assess the effects of those changes on profitability.
Spreading the Scenarios & Simulating Outcomes
Once the assumptions and risks have been identified, a series of different scenarios can be implemented to accurately assess the effects. This could involve changes in the following areas:
- Cash flows: assessing income, expenditure, and productivity scenarios.
- Financial Risks: modelling financial exposures and the potential effects on liquidity.
- Market Risks: modelling the potential effects of market risk on profitability.
- Debt & Capital Structure: assessing potential volatility and changes to the capital structure.
Simulating these scenarios will enable stress tests to be run to determine the effects of changing market conditions on the financial plan. By evaluating the results, potential risks can be historically projected and strategies can be implemented to cushion any potential impacts.
Building a financial model from the bottom-up can be a challenging process, but one that yields meaningful insights. Throughout this blog post, we discussed the steps involved in creating a robust bottom-up model, from gathering and organizing data to validating assumptions, simulating scenarios and adjusting assumptions, and finally completing the model.
Recap of Key Topics
- Fundamental drivers of financial performance.
- Analyzing and validating data.
- Creating assumptions and validating them.
- Simulating different scenarios.
- Adjusting assumptions and validating the model.
Benefits & Limitations of the Bottom-Up Approach
The bottom-up approach gives us the flexibility to take into account the insights from our fundamental drivers of the financial performance. It allows for our assumptions to be tailored to each business and its competitive landscape, allowing for a more accurate assessment than the top-down approach. The model can also be used for scenario planning to help with decision making.
However, it's important to be aware of the limitations of the bottom-up approach. It requires significant data collection and analysis, and decisions must be made carefully to avoid errors or oversimplifications.
Overall, the bottom-up approach provides an effective way to build a financial model that can be used to inform key business decisions.