Financial Modeling Vs Financial Forecasting – A Comparative Analysis
In the current scenario, most companies have a “pretty good idea” of the income flow and all the processes which work as the fuel running the engine speeding towards the goal of profitability and sustainability. The company financials have to be understood by not only the finance department but the board members also, to understand the processes and outcomes on a comprehensive and objective level. Financial Modeling and Financial Forecasting play a very important role here, although they are confused to be the same. Through this article, we focus on Financial Modeling vs Financial Forecasting differences to better understand both.
A common and repeated misconception is that Financial Modeling and Financial Forecasting are the same. To input the first point in the clarification of Financial Modeling Vs Financial Planning let’s begin with the basic definition of both terms.
Financial Modeling –
Financial Modeling is the process of evaluating the company’s past history with the current expenses and revenues and then predicting the accurate trend which will take place in the future. The modeling requires the preparation of balance sheets, income statements, cash flow statements, and other supporting schedules. The modeling helps in forecasting data-based informed predictions about the impact of any internal policy changes, external political turmoils, or economic policy or regulations on the company stocks and bonds. Businesses also refer to modeling whenever a new project is to be undertaken to estimate the costs to be incurred visa vi the profits expected to be generated. The Financial Model help in the board members to make an informed decision on whether to raise capital, divest, or grow the business organically.
Financial Forecasting –
Financial Forecasting is the process of predicting the future on the basis of past performance data of revenue generated, cash flow, expenses incurred, and the sales achieved. This data is compared to the prevailing market trends and informed assumptions are made for future performance of the company. Assumptions and guesswork are largely at play in this. It is done periodically to assure the stakeholders of the progress and long-term sustainability of the business. The Forecaster needs to master quantitative insights and be able to be creative in the evaluation by being able to predict different trends. This comparison of the fiscal data enables a company to make strategic decisions, thus, enhancing the collaboration between the business and finance departments. The forecasting is done to create a cushion against known risks like socioeconomic changes, stock market upheavals, varied business disruptions, and natural disasters.
Methodology and Approach
The methods adopted by the analysts add the second point to strengthening the concept of Financial Modeling Vs Financial Forecasting differences. Let’s take a brief look at the different methods applied in both :
Methods for Financial Modeling –
There are two categories under which the methods are classified, which are as follows :
- Internal Methods – These methods are used by the business for planning their budgets and decisions on whether to expand or consolidate the company product portfolio., these are as follows :
- Three Statement Model – This is the most basic model used by modelers. The method uses the Income Statement (company’s net income and net profit for that fiscal year), Cash Flow Statement ( changes in working capital, non-cash expenditures, investment, and finances to calculate the company’s net income, and Balance Sheet ( assets and revenue sources), to predict the net profit margin, growth rate and working margins.
- Discounted Cash Flow Model – In this method of modeling the future cash flows are taken into account, discounted, and after necessary adjustment applications, it is brought down to the present weighted average cost of the capital. It gives a clearer picture of the company’s actual value(enterprise value) and the shareholder’s value ( equity value). This helps in finding whether the company shares are underpriced or overpriced.
- The sum of The Parts Model – In this method includes combining various discounted cash flow models of marketable securities which are based on the present market value to arrive at the actual Net Asset value. It is also referred to as a break-up analysis of the company’s different divisions and assets.
- Consolidation Model – In this method all the different units and divisions of the company are consolidated as a single entity and the financial statements are calculated.
- Budget Model – This model is used mostly by the Financial Planning and Analysis team to prepare the budget for the forthcoming year or years. The expenses which can vary from being incurred monthly or quarterly and the income statement are the main components of this model and help in preparing actual budgets.
- Option Pricing Model – These methods are used to mathematically derive the pricing of the derivatives and stocks. Factors like the current stock price, market volatility, the risk free rate, the expiration time estimation, and the strike price of the option are taken into consideration. The Black Scholes Model and Binary Tree models are the widely used methods.
- External Methods – These methods are put into play by the modelers when a company is planning for consolidation or merger. The following methods are used:
- Leveraged Buyout Model – This model is most prevalent amongst Bulge Investment Banks and Private Equity firms. It deals with very complex debt modeling taking into account cash flow waterfalls, and circular references created by multi-layered financial structures. The main aim is to figure out the expected return on investment in a new entity by sponsors. The method evaluates whether the sponsor investing to acquire a new firm by taking debts will get the expected profit by selling it off in the future.
- Initial Public Offering Model – In this method, the evaluation is of the company’s potential stocks in the market and the expected price that an investor will be willing to pay for the same. This evaluation is done before the company goes public. Discount methods are applied in the model to ensure that the stocks are received at a good profit margin in the market.
- Merger & Acquisition Model – This method is used mostly when a company is planning either a merger or acquisition of another company. A thorough sensitivity analysis is carried out to predict the status of the valuation of the company if the deal is undertaken.
Methods for Financial Forecasting –
The Methods of Financial Modeling Vs Financial Forecasting have quite a significant difference. Financial Forecasting methods fall under two categories which are as follows :
- Qualitative Method: This method is generally used for new startups or business ventures and the prediction of margins. It is adopted as there is no historical data to do forecasting. As there are certain influencers that cannot be put into numbers thus this method is preferred. The experts related to that particular industry predict outcomes on the basis of their experience and judgment. The following methods are adopted under this category :
- Delphi Method: A facilitator is appointed to send questionnaires to industry experts to gather their forecasts on the performance of the new venture on the basis of market conditions. The results of these predictions are again sent to another panel of experts for trying to zero down to a consensual opinion. This method is adopted for a long-term prediction of the performance.
- Market Research – This method is best suited for small-time firms, and companies planning to venture into new services or products with a vision for short-term goals. A set of questionnaires is filled up and through various analysis models, a holistic insight is obtained into the fluctuating market conditions, customer behavior patterns, and competitors. Through this method, new companies can even make decisions for further resource requirements.
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When there is historical data available to make predictions, Quantitative Financial Forecasting methods are applied. There are the following main types of methods practiced in the industry :
- Straight Line – The future outcomes of a company based on its current growth rates are predicted by analyzing historical data using simple mathematical calculations.
- Moving Average – The financial forecasting patterns in this method take into account the past cost of production, sales growth, stock prices, revenues, and profits. It helps in identifying patterns and trends and is for short term forecasting.
- Simple Linear Regression – It works on forecasting trends on the basis of a linear relationship between dependent and independent variables.
- Multiple Linear Regression – In this method multiple linear relationships are taken into account because there is more than one variable impacting the performance of the company. This is the most complex, advanced, and correct result oriented forecasting method.
Financial Modeling Vs Financial Forecasting Advantages and Disadvantages:
In this section, we will be taking a detailed look at the reasons companies adopt Financial Modeling Vs Financial Forecasting and vice versa.
- Financial Modeling Vs Financial Forecasting Time Horizons – Time horizons in financial terms mean a fixed point in time till when the assumptions and predictions span.
- Financial Modeling – A company adopts Financial Modeling for a long term time horizon. While building a model many factors like economic factors, business factors, and other components that can impact the company’s revenues are taken into account. Thus, the models allow the analysts to predict the strategies for a longer period of time.
- Financial Forecasting – A company generally adopts the methods of Financial Forecasting when they want to invest less and look for short term forecasting. The forecasting generally includes predictable economic changes and business events, thus making the results accurate for a shorter time period of 1 to 3 years. In the longer term Financial Forecasting is not suitable are the accuracy of results reduces.
Financial Modeling Vs Financial Forecasting Complexity and Granularity –
The number of variables used and the level of accuracy required for the data explains the difference in the complexity and granularity of both the methods used by analysts.
- Financial Modeling – This method includes correlating multiple variables of a company like expenses, revenue, interest rates, taxes, capital expenditure, inflation, sensitivity analysis, debt schedules, and other variables which are complex. The data which the analysts used is collected over time and has to be high in accuracy to represent the correct financial activities like revenues, costs, and others of the company. The methods adopted are high in complexity.
- Financial Forecasting – This method doesn’t involve very complex mathematical model computations. The prediction of future revenues, sales, and cash flows is done in general with the help of simple methods like linear aggression, multi linear aggression, time series analysis, and other simpler methods.
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Financial Modeling Vs Financial Forecasting Assumptions and Sensitivity Analysis-
In both methods the factors and the scenarios taken into account for finding out the impact on the financial outcome are varied. Here is a brief description of the commonly used assumptions and the sensitivity analysis tests performed thereafter:
Financial Modeling –
- The assumptions taken into account for future revenue trends are based on pricing strategies, market shares, profit growth rate, and the cost of new customer acquisition. The sensitivity analysis encompasses predicting the trends in the pricing of the product and the sale volume when there are variations in the mentioned variables.
- The weighted average cost flow assumption takes into account direct costs, indirect costs, and fixed costs as variables. These variables are integrated into modeling to figure out the cash flow and the profit. Sensitivity analysis is done on these variables while carrying out cost assumptions.
- Financial Modeling for financing outlook makes assumptions on the variables like the selling of shares, debts financed, the current interest rates, and the plans for repayment of loans. The sensitivity analysis predicts the debt-to-equity ratio, loan repayment plan, and the expenses incurred by paying interest to be accounted for while doing profit analysis.
- Capital Expenditure modeling is calculated on the variables like buying fixed assets, buying new equipment, taking up new projects, and plannings for expansion. Sensitivity analysis predicts the impacts on return on investment and the expected cash generation.
- Market conditions and microeconomic factors like changes in laws and regulations, and policies are variables used in financial modeling. Sensitivity analysis predicts the impact of changes on these external factors in the long-term functioning of the business.
Financial Forecasting –
- Revenue forecasting is done using variables like the volume of sales, the pricing trends of products and services, customer demand, and the past profit generated. Sensitivity analysis predicts changes in these variables impacting the future revenue and financial prospect of the company.
- Expenses forecasting is done by taking variables like direct costs, variable costs, and indirect costs. Here not only the historical data and benchmarks are used for data collection, in addition, the estimates made by the management are also included. Thus, sensitivity analysis carried out to figure out the impact on cash flow and profitability is short termed.
- The variables like cost of production and cost of expansion are taken into account when forecasters calculate the future costs of goods sold. Sensitivity analysis is conducted to forecast the impact on the profit margins.
- Financial forecasting depends on variables like the payment of dividends, interest rates of loans, share prices, and debt financing. These variables have an impact on the cash flow, interest expenses, and capital costs, and the sensitivity analysis is done on the same.
- Working capital expenditure is impacted by variables like inventory levels, accounts receivables, and accounts payable. The Sensitivity analysis is conducted by variation impacts on the cash flow and liquidity of the company.
- Financial Forecasting deals primarily with assumptions in market trends and on the macroeconomic level. The variables impacting the forecasting are industry growth rates, GDP growth rates, inflation, and exchange rates. The Sensitivity analysis is conducted to study the impact of these external factors on the financials of the company.
Financial Modeling Vs Financial Forecasting Strengths –
Here is a comprehensive list of advantages of both methods:
Financial Modeling Strengths-
The following are advantages of adopting Financial Modeling Vs Financial Forecasting :
- Deeper Insight – Financial Modeling takes into account many drivers to be analyzed to predict trends at deeper levels. This identification of various drivers helps in knowing the business at a finer level. This, in turn, helps the company to be more aware of the factors affecting it and be better prepared for the impact of external factors on any level.
- Funding Strategy – Financial Modeling gives a clearer picture of the current cash outflow and inflow and the future revenue generation too. With this knowledge, the company can make an informed decision regarding the requirement for further debts, investments, and interest repayment expenses. Strategic goals can be set regarding better financial planning.
- Valuation Analysis – Financial Modeling forecasts the Rate of Returns, investment analysis, and the Net Present Value of the company. These help the company to know its financial position, which further helps the company to take strategic decisions on further investments, divestments, and merger and acquisition plans.
- Risk Minimization – As Financial Modeling predicts the financial outcomes due to the impact of various internal and external factors, thus the company is better prepared with risk mitigation planning.
- Accurate Outputs- Financial Modeling delivers more accurate data backed results, thus helping the company to make budgets, set business activities, and set goals which are less impacted by risks and help in a realistic view of the revenue structure of the company.
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Financial Forecasting Strengths –
The following strengths make Financial Forecasting a valuable tool in planning and goal setting :
- Strategic Planning – It helps in forecasting the future financial performance of a company, thus, helping in setting informed decisions while making future resource allocation and aligning the business operations with the business goals.
- Budgeting – Financial Forecasting throws light on the projected cash inflow, expenses, and revenue generated. A company can make more informed decisions regarding planning resource allocation, the need for investments, and financial targets.
- Performance Evaluation – The company can monitor the progress and performance of the business as compared to the forecasted goal. This helps in quicker identification of areas of improvement like the cost of production, changes in the profit goals, and other expenses.
- Cash Flow Control – Financial Forecasting gives a clearer picture of the financial structuring of the company to the investors, shareholders, lenders along with internal members. This enhances the level of trust in the company and proves beneficial in securing loans and investments. It also projects expected periods of cash requirement, enabling the company to plan the cash flow.
- Risk Assessment & Management – Forecasting helps in identifying the macroeconomic change impacts on the business financials in advance, thus, enabling the company to plan to mitigate predicted risks.
In conclusion, a business has to be aware of the drivers and their impact on the financial structure of the company in depth. Financial Modeling and Financial Forecasting are both a necessity in the present scenario for a company to succeed. Although Financial Modeling Vs Financial Forecasting choice depends on the amount of time investment and resource investment a company can afford. On one hand, Financial Modeling involves complex mathematical calculations and analysis, the predictions are generally for Mergers & Acquisitions, business investments and expansion, and sensitivity analysis on the impacts of microeconomic changes. These predictions are for the long term, that is more than 5 years.
On the other hand, Financial Forecasting is comparatively less costly and uses simple mathematical algorithms in forecasting. It is useful for the company to monitor the progress in the short term and integrate any improvements to be made at a faster pace. The macroeconomic impacts are predicted and faster strategic planning to mitigate the risks can be made.
Although Financial Modeling Vs Financial Forecasting outweigh each other with their strengths and also come with their own sets of limitations, yet a thoughtful integration of both proves beneficial for a company in the longer run.
Q. Financial Modeling Vs Financial Forecasting: What is the primary difference between both?
Financial Modeling uses complex mathematical models, and analysis of various drivers to project long-term predictions on financial decisions like raising capital, investments, mergers and acquisitions, the impact of government policies, and changes on the business for the long term.
Financial Forecasting makes predictions based on past data with market trends and management expectations. It uses simple mathematical calculations for forecasting and used to forecast the profits, cost of goods, resource allocation, cash flow, and the impact of macroeconomic changes on the business. The forecast is primarily for the short term.
Q. Financial Modeling Vs Financial Forecasting: What are the limitations of both models?
Financial Modeling is time consuming and expensive. Since modeling depends on the analysis of data, the accuracy of data impacts the results. Incomplete or even minor flaws in the data can result in major impacts on the outcomes.
Financial Forecasting is for the short term only. In the longer term, they are prone to inaccuracies. They are not very flexible and require monitoring for accuracy. Since opinions are also a driver in forecasting goals, they can be biased and flawed. Many microeconomic impacts cannot be accounted for, thus limiting its scope.
Q. Financial Modeling Vs Financial Forecasting: When is it suitable to use both models?
Financial Modeling is generally adopted by more established companies, because they are costlier, and need a major investment of time. Companies planning for large debt funding, major mergers or acquisitions, expansion of business, or planning for investment in major projects invest in it.
Financial Forecasting is adopted by new businesses that do not have any past data to make forecasts on, major revenue to invest in modeling, and want short-term planning. In general, forecasting is done to make informed decisions about resource allocation, sales, cash inflow, revenue generation, and impacts of predicted changes.