Predicting the future is hard, and fast-paced change makes it harder. Gaming various scenarios through financial modeling is important step in your business forecasting. Identify variables and assumptions, and put together a framework for taking a peek into the future of your financial performance.

In so many ways, numbers matter. Your employees care that the number on their paycheck is what they expect. Your bank cares that the number on the payment you make matches what you owe. You care that the amount your customers pay you matches what they owe. The financial health of your business matters in deep, impactful ways. When we talk about understanding the financial picture of a business, we generally break this down into two categories: historical and forecasted. We report on the historical financial performance as a way of telling the story of how we arrived at today. We can't change these financial stories, we can simply absorb and learn from them. Forecasted financials, however, help us make decisions about our future performance. By modeling the predicted financial performance of our company, we gain insights into the possible futures of the business, and we can make informed, rational decisions within the frameworks of those models.

Financial modeling can take many forms. In general, a financial model is comprised of a number of variables-- some of them inputs, some of them assumptions-- that can be used to predict the performance of something in the future. Financial models allow us to document and validate assumptions. In addition, financial models allow us to play complex "what if" games in which we identify multiple scenarios, speculate as to how variables will behave within scenarios, and see likely outcomes to those scenarios based on those variables. Through the use of financial modeling, we are able to make educated guesses about the future, and make associated plans for our business as a result.

Financial models have a lot of real world applications for businesses. We see financial models used a lot in general budgeting exercises. This generally takes the form of an annual budgeting cycle, with quarterly or semi-annual revision periods. A company will start with a "worst case", "best case", and "most likely" set of scenarios, and build a list of assumptions into the drivers of each scenario. For example, a company could adjust variables like top line revenue, labor costs, introduction of tariffs that squeeze margins, likely labor force cost increases, and other factors, and the resulting impact on projected income statements for the next year would paint a picture of performance given the list of variables. A company then manipulates these within the worst/best/likely scenarios to paint a picture of financial performance around which they can plan for the upcoming year.

We also see financial modeling used frequently in decisions around starting a new business line, adding or discontinuing a product, and hiring staff or letting go of staff. Much like game theory, financial modeling allows us to pressure test our assumptions with a series of interactions, and then tune our models to see how different inputs will yield different outcomes. As a result, the process of financial modeling can be instrumental to a business when forecasting future cash flows available for investment, for determining the ROI for a current investment, or planning for business model transformations in the future to allow your business to adapt to changes in the business climate.

Financial modeling is an exercise that requires creativity to identify relevant variables, financial know-hows to understand the workings of financial statements and business impacts, and process knowledge to build a model that accounts for the potentially complex interactions between time, variables, and assumptions. The consultants at GRAYBOX live and breathe this process, and can help your business make informed decisions for the best possible future results.