Introduction
Financial models are an essential tool for analyzing and predicting the likely value of investments. Building a financial model involves analyzing the revenue, expenses and balance of a particular investment to estimate its potential returns. Bottom-up financial modeling is a specific type of financial modeling that is particularly useful for taking an in-depth look at the individual components of a model’s balance sheet and revenues.
Background on Financial Modeling
Typically, financial models are built from three main perspectives: top-down, bottom-up and quantitative. Each approach has its own advantages and disadvantages, but when it comes to bottom-up financial modeling, the biggest benefit is its ability to help investors identify opportunities or risks that may not be visible in a top-down or quantitative approach. This makes it particularly useful for investors who are looking to make a deeper, more long-term investment.
Benefits of Bottom-Up Financial Modeling
- Allows investors to identify opportunities and risks that may not be visible in a top-down approach
- Provides a more detailed analysis, enabling deeper insights into a particular investment model
- Ideal for long-term investments, as it enables investors to better plan for potential risks and rewards
- Can help investors to anticipate any changes in their investments and adjust their strategies accordingly
Key Takeaways
- Identify opportunities and risks that may not be visible in a top-down approach
- Provide a more detailed analysis of an investment model
- Enables investors to better plan for potential risks and rewards
- Anticipate changes to an investment and adjust strategies accordingly
Understanding Bottom-Up Financial Modeling
Financial modeling is used to predict future values of a business, and help assess the estimated financial performance of the company. Bottom-up financial modeling is a special type of modeling which uses more detailed inputs compared to other forms of modeling. It is a great method for forecasting future income statement, balance sheet, and cash flow statement values.
Definition of bottom-up financial modeling
Bottom-up financial modeling is a type of financial modeling that emphasizes detailed assumptions at the individual revenue and expense line items in order to generate financial projections. It first estimates the different revenue and cost drivers of an entity and then combines these drivers to create a bottom-up projection for the company’s financial statements. The bottom-up model does not rely on macro-economic assumptions or the performance of industry averages to project financial results.
Benefits of this type modeling
There are many advantages of bottom up financial modeling that make it a preferred choice for forecasting financial statements. Some of the main benefits include:
- Creates a more accurate financial projection: Using more detailed assumptions provides a more accurate financial forecast compared to top-down models.
- Reduces estimation errors: By breaking the model down to individual items and drivers, the user can identify any inaccuracies in the financial statements.
- Increases user knowledge: Building a bottom-up model provides the user with a deeper understanding of both the drivers and assumptions.
- Reveals hidden trends: Solid understanding of a model enables the user to find hidden trends and patterns in the financial data.
Key Terminology
Building a financial model requires understanding certain key terminology. The following sections describe three relevant terms related to bottom-up financial modeling which every financier should know: inputs, outputs, and how bottom-up financial modeling differs from top-down financial modeling.
Inputs
Inputs are the assumptions about the environment in which the project or organization will operate. Inputs include future revenue, cost of goods and services, capital expenditures, borrowing costs, and taxes, as well as economic variables such as inflation and interest rates.
Inputs also include non-financial or non-quantitative parameters such as customer demand, sales growth, product penetration, and other factors.
Outputs
Outputs are the outputs of the bottom-up financial model, which are typically the projected financial position of the project or organization. Outputs include projected balance sheets, income statements, and cash flows.
Projected balance sheets include information such as the total assets and liabilities of the project or organization, while projected income statements include information such as net income, sales, and costs. Projected cash flows include information such as net cash flow from operating activities, investing activities, and financing activities.
Subsidiary vs. Top-Down Financial Modeling
Subsidiary financial modeling involves the development of a model from the "bottom-up," meaning from the detailed parameters of the project or organization. The decisions made during the model's development are data-driven, making it more reliable and objective.
Top-down financial modeling is the opposite of bottom-up financial modeling. It uses high-level assumptions to estimate the financial position of the project or organization, and is less data-driven.
Accounting Overview
Creating a financial model based on a bottom-up approach requires a thorough understanding of accounting principles and financial statements. In this section, we will review the essentials of accounting to get a better understanding of how to construct a financial model. Specifically, we will look at creating an income statement, examining common balance sheet items, and understanding the cash flow statement.
Creating an income statement
The income statement serves as the foundation of financial models. To create an income statement, you need to identify all key income sources, as well as any related expenses, which will determine the income or net profit. To arrive at an accurate income statement, you must factor in all sources of income, including sales revenue, interest income, gains on investments, and other income. It is also important to include all necessary expenses, including cost of goods sold, operating expenses such as payroll, depreciation, and other costs.
Examining common balance sheet items
The balance sheet is the most important financial statement for analyzing the financial health of a company. A balance sheet will show a company’s assets, liabilities, and owner’s equity in a given period of time. It is important to understand the different components of a balance sheet in order to properly analyze the company’s financial position. Common types of assets include cash, accounts receivable, inventory, and fixed assets. Common liabilities include accounts payable, debt, and deferred tax liabilities. Lastly, owner’s equity is the residual ownership claim after liabilities have been subtracted from assets.
Understanding cash flow statement
The cash flow statement is another key financial statement which will give an accurate picture of a company’s financial position by showing all the inflows and outflows of cash. The cash flow statement will show cash flow from operations, cash flow from investing activities, and cash flow from financing activities. A cash flow statement is essential for creating an accurate financial model as it provides insight into the company’s sources and uses of cash in a given time period.
Step by Step Guide
Building a financial model with bottom up financial modeling is no easy feat. Having a step by step guide for the process can be helpful for understanding and laying out the entire process. In this guide, we will cover the following steps: defining scope, gathering data, building the model, and testing results.
Defining Scope
In the first step for building a financial model, we need to define the scope. In other words, what are the parameters of the model? What type of data should it cover and what assumptions will we make when building it? Establishing these parameters upfront can be helpful in setting the guidance for the entire process.
Gathering Data
Once the scope of the model has been defined, we can then move onto gathering the necessary data. This data can come from historical records, research studies, or even financial statements. Depending on the complexity of the model, the amount of data needed can vary greatly.
Building the Model
The next step is to begin building the model. This can involve a range of tasks from defining the inputs and equations, to formatting the template and visually displaying the outputs. Having a good understanding of the data collected and the assumptions defined in the scope can help make this step smoother.
Testing Results
Once the financial model is built, it is important to test it for accuracy. This testing can be done by running through different scenarios to check for changing results, or comparing the result to actual data. If there are any discrepancies, this is the time to adjust and refine the model before it is ready for use.
Challenges to Monitor
When building a financial model with Bottom Up modeling, there are several key challenges to monitor. These include assumptions, data management, and progress tracking.
Assumptions
Assumptions are a necessary component when building a financial model, as a key component of connecting the bottom up analysis with a top-down result that is external to the model. It is essential to be mindful of the least favorable assumptions made in order to ensure that the model covers all possible scenarios, even if they are unlikely to happen. This can be a challenge as external data needs to be included, and forecasting requires analysis on a number of variables.
Data Management
Proper data management is essential for any financial model. Any missing data will create issues with results that are rarely discovered during model construction. Furthermore, properly displaying the data in a manner that makes sense during the build is also critical. As a best practice, models should be tested whenever data is added to the model.
Progress Tracking
Keeping track of progress of development of the model is key for any build. This progress does not just indicate how close the model is to completion, but also provides a way to review which assumptions have been made, what methods have been followed, and how data has been entered. Regular meetings can also be key, in order to provide feedback to each other.
Conclusion
Building a financial model using the bottom-up approach requires a disciplined process including defining financial objectives, researching and gathering data, building the projections, and validating the results. But the rewards are great – more accurate forecasts, more visibility into the future and greater data-driven decision making. In this blog post, we have covered each of these steps in detail to help you get on the right track.
Summary of Steps
In summary, building a bottom-up financial model requires:
- Defining financial objectives to identify the need for a financial model
- Researching and gathering data to project the necessary items
- Putting together assumptions in spreadsheets to form the projections
- Accurately validating the results for accuracy and credibility
Benefits from Financial Modeling
A financial model provides several benefits for businesses including:
- More accurate forecasts which eliminates guess work
- Greater visibility into the future based on sound data
- More data-driven decision making within organizations
- Development of better estimates, budgets, business cases and more
Referring to the Model in the Future
Today’s financial models will quickly become outdated. As such, it is important to regularly review and update the models to keep the information relevant. This should be done on at least an annual basis, though more frequently during times of rapid change.
By employing the steps outlined in this blog post and regularly checking the model, organizations can keep their financial model up to date and keep the organization running efficiently.