Financial Models, Forecasts and the 3 Financial Statements

Matthew Dziak

Projecting future performance is fundamental to finance and is a necessary driver of strategy. Private equity firms and investors rely on models to determine the potential opportunities that lie ahead for a Company to deem its worthiness to fund. Even though projections in the model point to a specific trajectory, circumstances throughout the year can have a dramatic impact on performance, which models aren’t keen on highlighting.

For this and several other reasons, which we will get into, models alone are not enough for most companies. Conversely, forecasts include past performance and actual results, while providing a structure that business units and teams can be held accountable to and strategize for as they work towards targets set in the annual budget. 

Pinpoint accuracy is not the driving reason for finance to forecast regularly either. Instead, it’s the process and directional trend of the forecast that is most important. In this post, we will compare models with forecasts, go over a few examples of each and how you should approach and analyze financial statements. 

Financial Model vs. Forecast vs. Budgets

First, let's define what a model, forecast and budget are and how they differ.

  1. A Model is an assumption-based estimate used benchmarking performance
  2. A Forecast provides a detailed projection of results that uses past results known as actuals to determine future performance
  3. A Budget is a detailed plan designed to achieve the targets established in a model by articulating decisions and assigning accountability

Financial Models

Models are useful to estimate the results of a given set of assumptions and generally are needed to satisfy ad-hoc requests from executives - they are also useful in selling beauty products, but that is a bit out of our realm of expertise. 

A common ad-hoc request sales and revenue leaders ask of financial planning and analysis teams to solve is the impact of hiring new sales staff. For example, a financial model is necessary to compare the potential impact of hiring three, six or nine new sales representatives who each take three months to ramp, and on average, 66 percent hit their quota, will have on net new revenue and revenue to full-time equivalent (FTE). 

Other examples of models: 

  1. Valuation models to estimate the value of a company at its current and potential state
  2. Cash flow models to determine the intrinsic value of a company
  3. Capital expenditure models to determine the feasibility of purchasing new equipment

Financial Forecasts

A Forecast is necessary to solve ambiguous assumptions and scenarios that could face the business. It is a projection tool used by management to achieve the overall budget goals. 

Unlike models, forecasts include actual results and therefore are more inclined to hold budget owners and decision makers accountable. Once the annual budget targets are set, forecasts are necessary to project outcomes and track progress.

CFOs and Financial Forecasting

Examples of what to forecast:

  1. Revenue/Sales to project the potential revenue and new sales for the business
  2. Expenses to project and manage spending, while influencing the allocation of resources within the budget
  3. Headcount to project the impact additional hires will have on total overhead costs, net income and Revenue per FTE

Monthly Forecasting Process

Some choose to forecast on a quarterly basis, but since the books are closed monthly, it is good practice to follow a consistent cadence for reporting and forecasting. Our team of former CFOs advocate for monthly forecasting and iterating on the forecasts as actual results come in. We like to refer to this as the Accountability-Based Forecasting

Monthly forecasts are useful in keeping track of actual results, while comparing the forecast plans and analyzing the variance. The results are useful for budget owners to assess the effectiveness of their strategies and make informed course corrections. For example, a cohort analysis of SaaS customers could be useful for sales and marketing leaders to target a specific industry and size of company that is a fit for its solutions.

Financial Forecasting that holds teams accountable

Analyzing Financial Statements 

Although it is the last word in FP&A, analysis is where the value lies. Investors, executives and boards all analyze financial statements to give them an informed view of the Company’s performance. If you were to choose just one of the three financial statements to analyze, it should be the balance sheet.

Why is the balance sheet the most important financial statement and not the cash flow or income statement? 

The balance sheet is the most important financial statement because it provides a look into the current health of the business and at any period of time recorded. It reveals the fundamental accounting principles of assets, liabilities and equity of a company which are necessary to determine the solvency and potential future outlook of the business. 

Comparing the actual past performance on the balance sheet on a monthly basis and how it tracks against the annual budget is critical to reach the desired outcomes in the plan. 

If performance is lagging mid-year, it’s an indication that strategies should be altered and a course correction is necessary to reach your annual targets. When analyzing financial statements, start with the basics. Consider fundamental accounting principles related to assets, expenses and liabilities and assess how they change over time.

Then incorporate the details you have about expenses, revenue sources and other inputs driving those outcomes into meaningful analysis. By providing budget owners and executive teams with these actionable insights, FP&A drives strategic conversations that result in desirable outcomes.

Building Integrated 3 Financial Statement Models

The 3 statement financial model consists of the income statement, balance sheet and cash flow statements. The order of the 3 financial statements should begin with an income statement, then balance sheet and culminating with a cash flow statement. 

When creating your income statement, always start with revenue, and work your way down. Everything from expenses, depreciation and capital structure are built off the revenue to lead to outcomes such as gross or net profit. For balance sheets, start with assets for the same reason. 

Finance Tip: If you develop an income statement and balance sheet, you can use them to then create the cash flow statement. 

Ideally, your 3 statement financial model should be integrated and dynamic, so when updates are made to one, the results are carried through to the other statements immediately — unless of course you are working in Excel and get the lovely, “Excel is not responding” error notification. 

Processing power and speed are two big deficiencies of Excel as it was never intended to manage large amounts of data. Excel is not a database and once the inputs of a model become too large trouble ensues.

Being that Excel is the default tool for many in finance, you can still use it at small companies and for certain reporting and analysis, but when you have large sets of data, you will need an integrated tool like our Excel Add-in which connects back to the web-based FutureView Platform. 

There is an endless range of Excel Add-ins available, but our Excel Add-in connects directly to our FP&A Platform, giving you full read and write-back access to your consolidated data without relying on Excel to store and process the transaction details. 

Experience The FutureView Platform Difference

The FutureView Platform provides a fully integrated 3 statement model out-of-the-box, and with our dynamic accounting system integrations with your general ledger, reports can be fully automated and ready to export once the books are closed. The same convenience can be carried through other company reports such related to sales, revenue, customer or any other dimensions applicable to your business.

That’s just the beginning, though, as we offer custom reporting dashboards, collaborative budgeting inputs with version control locking and detailed forecasting capabilities carried out from the high-level to each department, business unit and entity in an intuitive and efficient manner. 

Best of all, our team of former CFOs and finance executives are available to assist and guide you through any process optimizations and have you up and running in less than two weeks. If that is of interest to you, feel free to reach out and request a demo of our FP&A Platform. 

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