Assuming - Makes a Axx out of U & Me?
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ASSUMPTIONS & FINANCIAL MODELING
All of us have made faulty assumptions before and been made the fool, to be the donkey. As the saying goes when you assume something you make an Axx out of U and ME!! The reality is we have to make assumptions all the time in life and in finance. This is especially true when building a financial model. One of the key areas of every good model is the inputs/assumptions section. This is where we list all of our assumptions used throughout the model. Before we review some of the resources available to help us think through the process of making financial assumptions, let’s talk about making assumptions in life.
In life, the average person makes up to 35,000 choices a day and assumptions often drive those choices. This is why it is so important to think about assumptions and have a structure for evaluating the assumptions we use to make choices. Having a good framework for making choices will help us avoid blind spots. Take a moment to watch the below video as it will open your eyes to the number of choices we make and how often we all have blind spots when making those choices.
The reason this video was first is because it helps one realize that we all have blind spots and in life and financial modeling we should look for blind spots in our thinking as we make assumptions. If we do not take time to think through each assumption, we will allow our blind spots to be inputted into our assumptions and this can often lead to serious mistakes in life and financial modeling. Take a minute to think about your tendencies and some of the blind spots you might have and what you can do to overcome them. In the next section, we will get back to financial modeling.
Financial Modeling and Assumptions
When it comes to financial modeling you have to make lots of assumptions and if you do not put the proper time into making sound assumptions you will look like a fool. You can have the best-designed model, beautiful charts, well-structured formulas but if your assumptions are flawed all that goes out the window. You need to make assumptions, document them, and provide your rationale for why your assumptions are realistic. This is because at the end of the day a financial model is about predicting the future, and to predict the future we must make assumptions, and your model is only as good as the assumptions used to develop the model. Every model will be wrong, but the question is will the model help your business make the right decisions? As they say GIGO - "Garbage In Garbage Out"
Let’s review some of the common assumptions we make when building a model and then discuss a process for reviewing, and validating assumptions.
COMMON ASSUMPTIONS:
Model Length - How long should the model be 1 year, 2, years, 5 years, etc.
Model Frequency - Should we model weekly, monthly, quarterly, annual, other
Growth Rates - What rate will the revenue or expense grow at, seasonality adjustments, different product lines, etc.
Inflation Rates - We often need to assume inflation, over the last year this has become more important than ever
WACC - What is the hurdle rate for the project
Various Key Drivers - These will be project-specific but could include DSO, inventory turnover, capital structure, sales capacity, churn assumptions, hiring plans, capital expenditures, depreciation, etc.
Next is a list of things to consider as you are making and validating the assumptions in your model:
MAKING ASSUMPTIONS:
Understand which assumptions are the key drivers to your model and spend most of your time validating these assumptions
Group your assumptions into categories, example legal and government assumptions could be under the Legislation & Regulation category
Ask Questions! - Ask lots of questions of your business partners
Understand the business as best you can
Understand the strategy behind the project as this will help guide your assumptions
Conduct Scenario Planning - Having one scenario is not enough make sure to have multiple scenarios so you have a range of potential outcomes
Where available study industry reports and validate assumptions made with industry benchmarks
For all inputs that are given to you ask for the logic behind it and if it does not make sense push back
Chart/Graph out the impact of each assumption ask yourself is that realistic, does it make sense, does this chart/graph pass the sniff test
Ask a co-worker to look at the assumptions
Once you have completed your assumptions and gone through the validation process and conducted your scenario modeling do not change your assumptions to achieve the desired outcome. If you do not believe the results can be achieved speak up, after all, you are a business partner and advisor for a reason and you need to make sure you have shared your thoughts.
Finally think about your financial model and the strategy of the company. If your project is a good project it will fit the companies strategy and you will be able to see this in the P&L. A good project with a sound strategy should result in above average economic returns to the company. If the project does not generate a economic return, ask yourself why this is the case and make sure to point it out to the decision-makers.
Resources across the web to help you think about assumptions in your modeling
In this section, we review several website blogs and a few videos about making assumptions. Reviewing the below resources will be beneficial as you think about the process and come up with your methods for making and validating your assumptions.
The first resource is a blog about Strategic Assumptions. Strategic Assumptions – A Prerequisite to Great Strategies: 10 Tips (elg.net)
This article talks about how every business needs …”clear, and useful strategic assumptions. The article lists ten tips for ensuring your assumptions are helping you make a great strategy:
“Keep Your Head Out of the Sand” - Make sure you state all your assumptions and nothing goes unstated
“Stay above Hubris” - Check your arrogance at the door
“Really Question Your Assumptions” - Remove emotion from the process and ask the difficult questions to help validate your assumption
“Think of Categories Before You Think of Assumptions” - Group things into categories and then think of what assumptions belong to what categories
“Close the Assumption - Strategy Loop - Try to start with assumptions and build your strategy upon these assumptions
“Keep your Plan Relevant” - Constantly ask yourself if your assumptions are still valid and if the plan is still relevant
“Make Them Crystal-Darn Clear” - Make sure you document every assumption
“Connect Assumptions to Strategy” - Make sure you understand what assumptions each part of your strategic plan is built upon.
“Make Contingency Plans” - Have a contingency plan, when building a model conduct scenario planning
“Hedge Your Bests” - When planning hedge against your biggest risks to increase the chance of success
The above list is for strategic planning but many of the principles can be beneficial when building a financial model. The next three blogs all talk about assumptions as it relates to financial and or business planning.
The Key Assumptions of Your Financial Model - The first blog is from cfotemplates.com and it talks about the planning process and building assumptions for a model. It ends by giving a real case example of assumption building. The blog is short but provides some good guidelines for making assumptions
Modeling Assumptions by Victoria Collin - This blog focuses on what modeling assumptions are and how to think about them. This example primarily focuses on how we can use historical data to make our modeling assumptions and in particular modeling assumptions for building out a P&L and balance sheet.
Building Inputs & Assumptions Sheets - Excel Financial Modeling [Part 3 of 6] - This resource comes to us from Chandoo one of the experts on Excel. His website has a wealth of knowledge, and he has published a 6-part series about financial modeling, and section 3 focuses on inputs and assumptions. If you want a good real-life example to work through that gets you thinking about assumptions this is a good one to check out.
Next up are a few videos you can watch about financial modeling assumptions:
The first video is from a Financial Model Tutorial and is part 2 of 4. The video focuses on building out assumptions and walks through adding various assumptions to the model. The creator of the video Michael Herman also provides a link to download the model he uses in the video.
The second video walks through a practical example of making assumptions primarily around revenue for a business. This is a good practical example of someone going through the process much like the first video.
The next two videos focus more on the planning and assumption process for building your own business plan. Even though this may not relate exactly to building a financial model especially for those working in the corporate workplace it provides some good frameworks for thinking about your assumptions and the planning process one goes through when making assumptions.
Conclusion
Next time you're building a financial model make sure you spend a little more time thinking about and validating your assumptions. This is one of the most important parts of a model and one area that is often overlooked. Leave your thoughts below about how you go think through your assumptions when building a model.