Cash Flow Model: The Steps to Success (Part I)

As the investment community turns its attention back to fundamentals, we thought it fitting to revisit some of the basics that go into cash flow modeling. This brief article will highlight a financial model's core components and in a follow-up article, we’ll discuss the need-to-know phases of the build.

Our knowledge of these core components comes from creating and evaluating over 1,000 financial models, and while some have been more complex than others each modeler adheres to some basic principle and consciously or subconsciously executes certain steps in its construction.

The 3 Core Components of a Cash Flow Model

1. Inputs

Inputs include any piece of data that will affect the output. This may be a single data point or a vector of values that are referenced throughout the model. It’s also important to distinguish the difference between fixed data and variable data which is commonly referred to as an assumption.

Fixed Data

These are inputs that are unlikely to change over the evaluation period. This can be contractual terms such as the maturity and coupons of a loan. Or it can be a low-leverage assumption, meaning variable data which if changed even by a large degree will have little impact on the Outputs so setting them as fixed or not including them in the model at all may be appropriate.

Variable Data

These are inputs that are likely to change over the evaluation period. This can be event-driven such as severe weather events or economic downturns. The variable data or assumptions should consist of only those that are high-leverage, or data if changed by a little would have a significant impact on the Outputs. Since infinite variables can affect Outputs, you may waste valuable time building low-leverage assumptions. To avoid that you may want to speak with a subject matter expert before starting your build process.

2. Model Structure

Rules for how the data Inputs interact with each other forms your model structure.

Industry Standards

Often model structures, meaning both format and calculation methodologies are relatively standardized within each industry. To ensure your model is intelligible to someone else with whom you may be presenting or handing it off too it is best to learn those industry standards.

Documentation

Documenting how your data interact with each other, what is commonly called your data map, is also important to ensure the continued accuracy of the model and will eliminate timely deep dives back into the model. At the end of the process, you will have a robust library of formulas that you’ll be able to use repeatedly.

3. Outputs

The results that are produced when the Inputs are introduced to the Model Structure. These results provide the stakeholders with insights that help them make investment decisions and manage current and future project resources.

Forecast vs Actual

It is important to note that models are linear representations of the world, if I change this, I will get that. We know that the world is non-linear, meaning despite best efforts to select the highest-leverage assumption there are always going to be outlier events, the pandemic case point, that can greatly impact the output so the results can vary greatly from the model.

Time Horizon

Lastly, it is especially important to consider the time horizon that we are evaluating. Generally, the further out into the future the weaker the predictive power of the results. Each project that you are modeling will have different effective modeling ranges. Some may be effective for 30 years while others are no more than 12 months. This is another instance where speaking with a subject matter expert may help you consider the right time horizon for your project. Understanding the predictive time horizon before starting your build will help you save time and undue false expectations which can drive poor decision-making.

When evaluating a project whether it’s a new or existing business or a complex financial instrument it’s important to start from a place of truth because setting realistic and achievable goals is critical to success. Committing ideas to paper, or a favorite spreadsheet, makes those ideas come to life. When information is laid out in a way that is easy to comprehend the opportunities and pitfalls will be hard to miss.

If you found this article helpful, please come revisit us next week for part 2 of this series on the 6 essential phases of building a cash flow model.

Author: Benjamin Armenti, President