Forecasting with a Bottom-Up Financial Model

Introduction

Forecasting is an essential part of business planning and measurement, often involving the use of a financial model. A bottom-up financial model, in particular, is a powerful tool that allows budget forecasting and analysis of expected revenues and expenses to better understand the financial health of an entity.

Broadly speaking, bottom-up forecasting involves assessing the components that make up the total budget or forecast and then building up a budget or forecast from these individual components. This approach can give users a better understanding of how a budget or forecast is composed and how its components interact with each other.

In addition to providing insight into the composition of a budget or forecast, there are a number of practical benefits for companies that use bottom-up forecasting models. Here are some of the most important benefits:

• Allows teams to assess budget or forecast components individually or in aggregate.
• Enables better cost-control and resource planning.
• Gives teams the ability to accurately adjust forecast or budget components based on current economic conditions or internal changes.
• Provides insight into trends and performance indicators.
• Helps teams to accurately assess the financial impact of proposed investments or changes.

Key Takeaways

• Bottom-up forecasting allows teams to assess budget or forecast components individually or in aggregate.
• Enables better cost-control and resource planning.
• Gives teams the ability to accurately adjust forecast or budget components based on current economic conditions or internal changes.
• Provides insight into trends and performance indicators.
• Helps teams to accurately assess the financial impact of proposed investments or changes.

Calculation of Weighted Average Cost of Capital

The weighted average cost of capital (WACC) plays an important role in the bottom-up financial model. WACC is determined by the return the investor requires for investing in a company's project/operation/business. It is a key metric used to help business owners make investment decisions, therefore it is essential to determine an accurate WACC.

Components of Cost of Capital

WACC is the weighted average of two specific costs: the cost of equity and the after-tax cost of debt, which themselves can be broken down into further components.

• Cost of Equity: The expected return that a company must provide stockholders in order to induce them to purchase or hold the company’s stock. The cost of equity is determined through a capital asset pricing model (CAPM).
  • Risk-free rate: The interest rate on US T-bills, which can be seen as a proxy for the minimum payment on all free-market investments
  • Expected Market Return: The average of all stock market returns
  • Beta Coefficient: A measure of the relative volatility of a security in comparison to the market as a whole
  • Market Risk Premium: The return the market offers above and beyond the risk-free rate
• Cost of Debt: The cost of debt is often defined as the after-tax cost of borrowing. The cost of debt is based on the interest rate on debt, which should include the cost of any fees associated with the debt.

Assessing the Risk Profile of Businesses

In order to assess the risk profile of businesses, analysts must consider the company’s financial statements, and most importantly, the debt-to-equity ratio. Higher levels of debt can lead to an increase in the company’s cost of capital due to the additional risk assumed by debt holders. Additionally, analysts must consider the size of the company and its competitive landscape, as well as any macroeconomic or industry-specific risks.

Calculating the Cost of Capital

The weighted average cost of capital is calculated by multiplying each component of the cost of capital by its respective weight and adding the results. The weight of each component of the cost of capital is determined by the proportions of each component to the total capital structure of the company. For example, if the company is funded by 50% debt and 50% equity, the cost of debt would be 50% of the total weighted average cost of capital and the cost of equity would be the other 50%.

Forecasting Forecasted Financial Statements

Producing a comprehensive bottom-up financial model can be an invaluable tool for companies to prepare for their upcoming performance and to identify both their strengths and weaknesses. Forecasting financial statements allows a company to project what their income statements and balance sheets could look like in the future, and is an important part of understanding a company’s financial performance. Here, we will discuss how to do of forecasting financial statements using this bottom-up model.

Identifying the key drivers of future performance

The first key step in the forecasting process is to identify the drivers of the company’s future performance. This may include key products, services or markets, expenses or investments over the forecasted time period, and changes to working capital and overall capital structure. Once the primary drivers of performance have been identified, they should be expressed as clearly as possible.

Estimating forecasted income statements and balance sheets

After the key drivers have been identified, it’s time to develop the forecasted income statements and balance sheets. This will involve creating initial estimates of revenue, expenses, depreciation and income taxes, as well as the company’s balance sheet items like cash, accounts receivable, inventory and liabilities.

Once the forecast is created, it’s important to decide how best to display it. The most common methods are to use either a tabular format or a chart. The tabular format allows for more exact numbers and more details, while a chart may be more suited for executive review. Whichever format is chosen, it's important to remember that all assumptions and details behind the forecasts should be clearly stated and properly documented.

It’s also essential to check the reasonableness of the forecast. For example, estimate the impact of changes in accounts payable and other liabilities and make sure they are within feasible limits. Another consideration is to estimate the effect of inflation or deflation on the company’s future performance. Finally, check the financial forecasts to make sure they are in line with the company’s overall strategy and any external factors, such as changes in the competitive landscape or the economy.

Putting It All Together

Forecasting with a bottom-up financial model requires the effective integration of inputs from various departments in order to paint an accurate financial picture of the company's future. Once all of the relevant components are established, it is important to ensure that the assumptions formed for the forecast are accurate and achievable. Before delving further into the process, let's look at some tips for determining which components to include when creating the bottom-up financial model forecast.

Setting Assumptions for the Forecast

The assumptions made during the creation of a bottom-up financial model must be robust and reflect the realities of the company and its corresponding industry. Furthermore, the assumptions must be tested to ensure their efficacy should changes occur in the future. When making assumptions, it is essential to include important factors such as the impact a fluctuation in demand could have on the forecast, the availability of resources in the marketplace, and any other adjustments that could come about as a result of an internal or external change.

Tips for Determining Which Components to Incorporate in the Model

The components included in the bottom-up financial model will depend on the company, the industry, and the forecasting period. Generally speaking, higher-level organizational components like sales, labor, and overall operational costs should be incorporated. It is important to also include non-recurring expenses, capital expenditures, and any short-term special projects.

The foundation of the forecast should be for the simplest version of the model, which then can be developed further to include all the necessary information. Additionally, the forecasting period should involve planning for at least one quarter of the next fiscal year, as this will ensure that the forecast is obtainable and that the company will have a realistic set of plans.

• Inputs from various departments must be included in order to create an effective bottom-up financial model.
• Assumptions should be robust, realistic and tested for accuracy.
• The components included in the bottom-up financial model will depend on the company, the industry, and the forecasting period.
• The foundation of the forecast should be for the simplest version of the model which can then be developed further to include all the necessary information.
• Forecasts should include planning for at least one quarter of the next fiscal year.

Determining Long-term Sensitivities

Determining long-term sensitivities with a bottom-up financial model requires an understanding of value at risk (VAR). VAR is defined as a measure of the likelihood that a portfolio of assets will lose significant value over a given period of time. This is an important tool for assessing risk over the long-term and can help identify the different sources of risk in a portfolio.

Use of Value at Risk (VAR)

VAR can assist with forecasting in that it can quantify the potential risk of a particular portfolio of investments. In addition to understanding the risk associated with a particular portfolio, VAR can also help identify sources of risk beyond the instruments and derivatives of the portfolio. From this, managers can make strategic decisions about which areas of the portfolio are most likely to suffer from a large risk, and plan for its mitigation.

Risk and sensitivity analysis

Once the potential risks associated with the portfolio have been identified, a risk and sensitivity analysis can then be conducted. This examines the different factors that may affect the portfolio, such as individual investments, market conditions, and macroeconomic factors. By understanding the different factors that can impact the portfolio, managers can take steps to mitigate the potential risk associated with different investments. These steps might include diversifying investments, reducing risk, hedging, and other strategies.

Moreover, a sensitivity analysis can identify the assets in the portfolio that are most affected by changes in market prices. This is useful in developing strategies that protect investments in the face of potential market shifts, as well as identifying which assets to invest in or avoid. Ultimately, a comprehensive bottom-up financial model will be able to capture the different sources of risk and produce forecasts that account for long-term sensitivities.

Disadvantages of Bottom-Up Models

After understanding the core components of a bottom-up financial model, it’s important to recognize that this approach has its own set of shortcomings. Namely, the potential limitations of assumptions upon which the model’s estimates are derived, and the complexities that arise when attempting to simultaneously model multiple entities.

Limitations of Assumptions Behind the Model

When creating financial projections that have high levels of accuracy, it is key to be mindful of the underlying assumptions made during the model-building process. These assumptions are used to set a baseline for the forecasting process. By analyzing historical results and expert opinion, along with recent industry trends, assumptions should aim to be as accurate as possible. If the basis of assumptions is inaccurate, any results derived from the bottom-up financial model may not be realistic.

When selecting assumptions, it is important for the individual building the model to achieve an achievable and well-defined expectation that can be used as the foundation for forecasting. Even though assumptions will rarely be correct on first attempt, adjustments can be made as needed to obtain more accurate results.

Challenges When Simultaneously Modeling Multiple Entities

Bottom-up financial models involve a fair amount of complexity, as they typically focus on a single asset or entity and involve a fair amount of detail. This can quickly become unwieldy when trying to model multiple entities simultaneously. Each object needs to be defined, built and tracked separately; this often results in higher levels of complexity, with the potential to lead to errors and inaccurate results.

Balancing the need for accuracy, while not making the model overly complicated or time-consuming, is a key challenge when attempting to take a bottom-up model and apply it to a larger group of assets or entities. The model-builder will often have to balance these two needs, as sometimes the most accurate forecasting results may require a balancing act with respect to the model’s complexity.

Conclusion

Bottom-up forecasting, a process in which individual business units and projects or products are the basis for forecasting, is increasingly popular among businesses. Forecasting with a bottom-up model offers a number of benefits that are not available with a top-down model.

Review of Benefits of Bottom-Up Forecasting

• Allows executives to look at the performance of individual business units and projects.
• Provides the ability to identify trends and weaknesses earlier and more accurately.
• Demonstrates the risk associated with market and external conditions.
• Reveals new opportunities for investment and growth.

Recap of Key Steps of Implementing a Bottom-Up Model

• Review internal data sources.
• Gather data from external sources.
• Analyze data to generate insights.
• Develop forecasts for individual business units or projects.
• Aggregate the results to assess overall trends.
• Identify areas of risk and opportunity.

Bottom-up forecasting can result in more accurate forecasts, improved performance, new opportunities, and decreased risk. With key steps of implementation in mind, businesses should consider the potential benefits to their company and consider implementing a bottom-up forecasting model.