FREE online courses on Refresher on Financial Planning - Chapter 4 - Financial Models

 

Budgets can be prepared with the use of formal models which take advantage of techniques like regressions and sensitivity analysis. Models are built around the collection of equations, logic, and data that flows according to the relationships between operating variables and financial outputs. Financial variables (costs, sales, investments, taxes, etc.) can be manipulated by the user so that the user can see the outcome of a decision before it is made. This can help facilitate strategic thinking within the budgeting process. Two types of financial models are simulation and optimization. Simulation attempts to duplicate the effects of a decision and show its impact. Optimization seeks to optimize (maximize or minimize) a forecast objective (revenues, production costs, etc.).

 

Financial models provide decision support services for improvements within budgeting. Some of the benefits of financial models include:

 

* Shows the results of planning under a variety of assumptions, allowing the user to assess the impacts of estimates that have been used.

* Generates the Budgeted Income Statement and Budgeted Balance Sheet as well as forecasted financials by business unit or department.

 

In order to build a financial model, we need to establish variables, parameters, and relationships. Additionally, we can divide variables into three types:

 

1.      Control Variables: The inputs that the company can control, such as the level of debt financing or the level of capital spending.

2.      External Variables: Inputs that the company cannot control, such as economic conditions, consumer spending, interest rates, etc.

3.      Policy Variables: Goals and objectives of the company can impact the expected outcomes. For example, management may set targets for sales, profitability, and costs.

 

Parameters are the baselines or boundaries for the financial model. For example, the level of debt may have a minimum and maximum value. We also will set our beginning account balances within the financial model.

 

Relationships are the logic and specifications required for making things work. For example, the Budgeted Balance Sheet will require that Assets = Liabilities + Equity. Several equations will be used within the financial model. Many of these equations will be relational; i.e. if we change sales prices, total revenues will change. Equations are tested and added to the financial model to make it complete. Equations can be expanded into business and decision rules so that users do not have to worry about calculating things like return on equity. The financial model takes care of critical rules for running the business or making decisions.

 

EXHIBIT 15 - FINANCIAL MODEL FOR CASH

 

Relationships (Equations):   

Cash(t) = Cash(t-1) + Cash Receipts(t) + Cash Disbursements(t)

Cash Receipts(t) = (a) x Sales(t) + (b) x Sales(t-1) + (c) x Sales(t-2) + Loan(t)

Cash Disbursements(t) = Accounts Payable(t+1) + Interest(t) + Loan Payment(t)

 

Input Variables in Dollars:

Sales(t-1), Sales(t-2), Sales(t-3)

Loan(t), Loan Payment(t)

(a): Accounts Receivable Collection Pattern in current period

(b): Accounts Receivable Collection Pattern one period ago

(c): Accounts Receivable Collection Pattern two periods ago

(a) + (b) + (c) < 1.0

 

Parameters (Initial Values in Dollars):

Cash(t-1), Sales(t-1), Sales(t-2), Bank Loan(t-1), Accounts Payable(t-1)