Introduction
A bottom-up financial model is a model that forecasts a company's financial statements and related metrics by starting with the basic component parts of the company. It is an important tool for financial and strategic planning, such as determining cash flow, valuations, and other performance analysis. It is also key to preparing a budget and a business plan.
Building a bottom-up financial model includes understanding key elements of the company, assessing the company's future financial indicators, and then calculating projections based on future factors. Having a comprehensive financial model in place is essential for any business, regardless of size or complexity. The following are the best practices for building a bottom-up financial model.
Definition of Bottom-up Financial Model
A bottom-up financial model is an approach to financial modeling by which a company’s financial statements are forecasted from the ground up. It begins with the individual components of the company, including assets and liabilities, income, costs, and expenses, to create a detailed picture of the company’s financial health.
Why it is Necessary to Build One
A bottom-up financial model is key to any company's long-term financial planning and provides a deep-level understanding of the elements of the business. It is a powerful tool used to determine a firm's expected value, potential cash flows, performance indicators, budgeting, capital budgeting, and other fiscal matters. It provides a clear blueprint for the company’s future in both its immediate and long-term outlook. For startups, a thorough bottom-up financial model can be the difference between success and failure.
Key Takeaways
- Understand key elements of the company to help create a thorough bottom-up financial model
- Create projections based on future factors to achieve a comprehensive financial model
- Use a bottom-up financial model to determine value, potential cash flows, performance indicators, budgeting, and other fiscal matters
- Startups should create a bottom-up financial model for long-term success
Data Inputs
In order to accurately construct a bottom-up financial model, reliable and accurate data is essential. As such, it is important to understand what types of data are needed and the sources these data can be obtained from.
Types of Data Needed
Typically, the data needed to create a bottom-up financial model will depend on the context and industry the model is being built for. Generally, the data required relates to an organization’s historical financial performance, competitors’ performance, industry trends, macro-level trends, and more.
Financial data could include sales, costs, overhead expenses, capital expenditures, tax payments, and any other financial performance-related metrics. Additionally, non-financial data could include customer behavior, company goals and objectives, employee data, or any other non-financial performance-related metrics. Once these types of data have been identified, it is important to gather the most relavent sources.
Sources of Data
The sources of data used to construct a bottom-up financial model vary depending on the context and industry being analyzed. Data sources can include public financial statements, industry-related reports and studies, economic reports, surveys, and customer feedback, among others.
It is also important to include data from both internal and external sources. Internal sources could include company records, customer data, or employee data. External sources could include outside market analyses, industry surveys, or macroeconomic data. Additionally, it is important to use data that is as up-to-date as possible.
Base Assumptions
Creating a financial model requires numerous base assumptions to be made in order to accurately capture the overall financial performance of the organization. The base assumptions must be realistic and achievable in order to produce accurate projections. To ensure that the base assumptions are realistic and achievable, depth analysis must be done around the economics of the business or industry, market trends, and management performance.
Reasonable and Achievable Assumptions
When creating a financial model, the base assumptions should be reasonable and achievable. When assuming cash flows, expenses, and other aspects of the financial model, it is important to have a practical view of what's likely to happen and thus, the assumptions should be based on realistic expectations. Relying on historical data, as well as research on the industry, company, or project can help provide a basis for making these assumptions.
Sensitivity Analysis
In addition to making reasonable and achievable assumptions, performing sensitivity analysis is also important. Sensitivity analysis is a critical tool used in financial modeling to determine how sensitive the assumptions are to changes in inputs. By performing sensitivity analysis, one can identify any potential risks or opportunities associated with certain assumptions. By understanding these risks and opportunities, one can make better assumptions and develop a more accurate financial model.
Sensitivity analysis can be performed either through scenario analysis or through the use of sensitivities spreadsheets. Scenario analysis is a technique used by finance professionals to assess how the outputs of a financial model can change when certain assumptions are modified. Sensitivities spreadsheets are numerical tools used to understand the impact of certain variables or assumptions on the outcome of the model.
Model Outputs
When building a bottom-up financial model, what ultimately matters is the outputs it provides. A bottom-up model should provide comprehensive outputs so decision-makers can evaluate the financial performance of a company and make informed investment decisions.
Financial Performance Metrics
The bottom-up financial model should provide financial performance metrics such as Return on Equity (ROE), Return on Assets (ROA), Gross and Operating Margins, Free Cash Flow (FCF), Earnings Per Share (EPS), and Debt Ratios. These metrics would provide answers on the company's liquidity, profitability, financial health, and cash flow.
Valuation Measures
The bottom-up financial model should also provide data that can be used to calculate valuation measures. The model should compute the company's enterprise value and equity value and report on the price-to-earnings ratio, price-to-book ratio, dividend yield, and other relevant measures.
These outputs should be easy to interpret and provide decision-makers with the tools they need to meaningfully assess a company's fiscal performance. By being comprehensive, the bottom-up financial model can help users make informed investment decisions.
Processes and Systems
When building a bottom-up financial model, it's important to consider the processes and systems that you need to have in place to make sure the model is effective and easy to use. Here are some best practices for the processes and systems related to a bottom-up financial model.
Access and Control of the Model
Those who will be using the model should have appropriate levels of access and control. Depending on their job roles, they may need to be able to edit certain aspects of the model, but they may not need to have access to all of the information. It's important to have a system in place to make sure unauthorized users do not have access to the model.
Automating and Linking Between Spreadsheets
An effective bottom-up financial model should automate as many steps as possible to save time and reduce errors. Additionally, linking information between spreadsheets is helpful in making sure all data is up-to-date and accurate. This can be accomplished by leveraging functions such as VLOOKUP, SUMIF, and INDEX/MATCH.
Creating macros within the model can also save time by automating tasks such as data entry, validation checks, and formatting changes. These macros can be written in VBA or other scripting language.
Model Documentation
Building a bottom-up financial model is a complex task that involves making a series of decisions, assumptions, and estimates. It is critical to ensure that these thought processes and decisions are clearly documented throughout the modeling process. Documenting the model not only allows others to understand how specific assumptions and calculations are made, but provides visibility into changes in the model over time.
Accurately Recording Changes and Assumptions
Any changes or assumptions made while building the model should be documented, as they are crucial to understanding the basis of the final model results. For example, if assumptions are made to model certain future cash flows, the assumptions should be noted and tracked in the changes sheet.
Key Processes and Assumptions
The most important processes, assumptions, and calculations should be identified and tracked in the documentation. This can be in the form of tables or written descriptions that explain the assumptions made or adjustments made to inputs after the initial build. Additionally, it is important to document the range of sensitivities around significant assumptions that have a material impact on the overall performance of the model.
- Create a separate worksheet for assumptions and track changes over time
- Create a summary table documenting the key assumptions and calculations in the model
- Include a written explanation of the key processes and assumptions
- Review the sensitivities associated with key assumptions to ensure they do not materially impact the overall model performance
Conclusion
Building a bottom-up financial model requires a good understanding of the underlying fundamentals and thorough data analysis in order to achieve accurate and reliable results. Best practices include leveraging historical financials and drivers to project future assumptions, planning for sensitivity analysis, understanding the financial statement linkages, and organizing the model structure.
Adopting these best practices brings about a number of advantages. Firstly, by utilizing historical financials, a modeler can define the base case assumptions and plan out the alternative scenarios quickly and efficiently. Additionally, analyzing the financial statement linkages provides a deeper understanding of the company's performance. Lastly, with a well structured model, the modeler can easily track the movement of the data and ensure consistency and accuracy of the results.