THE KEY ASSUMPTIONS OF YOUR FINANCIAL MODEL

Planning Process

The planning process should always start with goal setting – that is the part of the process that is so often omitted and forgotten, although it definitely shouldn’t be. Before you put any effort you should understand the reason you are doing so. Define what is expected from the company – high level of profits, great dividend payout rate or a high growth rate.

Once corporate goals are clearly defined, we jump to the assumptions of the model. The assumptions shall state the main external factors that affect the economy.

• What is the present state of economy in the world and in what state do you predict it is going to be?
• What will the inflation rates and currency exchange rates will be?
• Will there be any new business expansion projects undertaken by the company? etc.

The main goal for explicitly setting the assumptions is to get a common view over the next planning period among all the members of your team involved in the financial planning process. It is crucial for each department to have the same vision of what is expected for the company. Here is an example of what could happen if each department works separately in so-called “silos”.

Painful experience

One of AG Capital’s customers, a retail company working in the luxury goods sector, was severely hit by the financial crisis of 2008-2009. The company was quite successful and able to keep its cash balance positive during the restructuring process. However, one of the methods to achieve this was keeping purchases very low and selling the older items that were already in stock.

When the restructuring was over, the company’s marketing department was informed that, from now on, the company would grow sales at full speed and would allocate some funds for media advertising. The marketing manager decided to promote a special category of goods that had the highest markups.

However, during the planning process for the campaign it turned out that the purchasing department was unaware that the restructuring was over and was still keeping purchase levels low.

The company had to drop the marketing campaign since they had almost nothing to sell.

Categorization of assumptions

The main categories that need to be covered in the assumptions are as follows:

1. Economic factors – industry growth, GDP growth, level of inflation, interest rates, etc.
2. Currency rates – especially if your company is involved into international business.
3. Possible changes in the applicable taxes in every market your company is serving.
4. Changes in pricing/markup policies of the company. For exchange-traded goods or raw materials you need to use a unified forecast for the price fluctuations of the goods.
5. Possible expansion projects within the company – whether and when you plan to build a new factory or open a new shop. It is a good idea to let your HR department know these plans in advance so that they are able to budget their expenses accordingly.
6. Other significant risk factors to the company.

It is a good idea to build a spreadsheet model for at least some of the projections you will be using for your budgeting purposes. Then you will be able to quickly change the assumptions if needed and will be able to automatically recalculate all the numbers in the model as well as to evaluate different scenarios that might happen during the course of the year.

Real case example

An example of a key assumption sheet is shown on the left. This company budget projects flat industry sales (Sales +/- vs. plan); an inter-bank borrowing rate of 2%, specific sales tax rate for each of its shops, as well as a projection on the applicable tax system. All of these numbers are automatically linked to corresponding parts in the budget and will automatically adjust the final results should they be changed.

The numbers in the budget are forecast and all of the numbers are based on assumptions. When trying to predict the future it is quite easy to make mistakes. Some of the mistakes could be very costly while others will have a very little impact on the results.

For instance, fuel prices are very important to a transportation company and not very important to a professional services company. The price of fuel is influenced by price of oil while the price of oil is influenced by many different factors. It is quite difficult to precisely forecast oil prices so there are often errors in fuel price estimates. The cost of an error would be much higher for a transportation company that operates a fleet of trucks than for a financial services company that does budget analysis.

It is important to identify the assumptions that have the greatest impact on the company’s results, to double-check them and possibly to leave some reserve for the downside risk as well.

Financial modelling is easy when you know how to do it. Use a spreadsheet to create a flexible budget that makes it easy to change assumptions. You don’t even have to create the spreadsheet yourself – pre-built templates are available on cfotemplates.com. Moreover, assumptions will help you to “play” with your inputs to find out the right scenario for further development of your business.