Developing Reliable Financial Models

There has been significant discussion among economists regarding the inability of various economic and financial models to predict or help anticipate the economic crash of 2008. Most economists and financial analysts are now dealing with their failure to predict one of the biggest recessions in U.S. history. Now they have to determine a way to fix the failed models and avoid making the same mistakes in the future.

While the subject of macro-economic models and why they failed is a little beyond most peoples’ understanding (mine included), it does raise an interesting question: What makes up a good financial model and/or forecast for a business? This question may be relevant as 2010 comes to a close and planning for next year (and the next five years) begins.

While there is no magic formula for developing a good financial model or forecast, there are a number of things to consider that can increase the reliability and usability of your next forecast:

  • Don’t make the model too complex – Many people believe an accurate financial model, requires layering hundreds of assumptions and variables into the model. However, it’s better to focus your time on the key variables that are going to truly affect your business. Understand that, even at best, this is still just a projection of an unpredictable future, and don’t waste time researching variables that don’t have a significant impact on your business.
  • Make your model flexible – The future is unpredictable, and even the best model can’t anticipate all of that unpredictability. If you’re attempting to forecast revenue and profit for McDonald’s next year and the price of beef goes up 20%, you want your model to be able to easily adapt to that price increase.
  • Understand that a model will never be 100% accurate – When developing a financial model once, a colleague of mine said, “I don’t know why we even do it – we’re proven wrong the next day.” But, that only applies if you believe the goal of your model is to predict the future, and not to help manage your business. And, if you can predict the future, you’d be in Vegas, not behind a desk projecting revenue.

Use the original model to understand what happened during the year. For example, “I thought prices would increase by 7%, but they only increased by 3% because consumer spending was less than anticipated.”

Or, continue to update the model on a regular basis to reflect key changes. Whatever helps you to manage your business.

  • Never underestimate the value of sensitivity analyses – You’re using the model to help manage your business. So, run some sensitivity analyses on your key variables. If a 2% change in price causes a 20% reduction in profitability, you know you need to manage prices closely and be prepared to take action if prices drop.

These are just a few of the key considerations to make when developing a financial model and forecast.  If you need assistance developing a financial model for your business, please contact Steve Thimons at 412-697-5281 or sthimons@schneiderdowns.com.

 

 

 

Schneider Downs provides accountingtax, wealth management, technology and business advisory services through innovative thought leaders who deliver the expertise to meet the individual needs of each client. Our offices are located in Pittsburgh, PA and Columbus, OH. 

This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.

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