Types of Assumptions in Financial Modeling

Building a solid financial model starts with making the right assumptions. Financial modeling is one of the most powerful tools for planning business decisions and forecasting future performance.

Financial projections assumptions help predict revenue, cash flow, and overall financial performance. Models built on these assumptions can also assess the impact of different strategic decisions on your business.

Let’s take a look at what financial assumptions are, the different types there are, and how they play an important role in financial modeling.

What Are Financial Assumptions?

Financial assumptions are the basis of your business plan. They are educated, researched guesses about future conditions that help forecast your company’s revenue, costs, capital and more.

To do this, you should base on your historical financial data. However, new startups may lack historical data, which makes financial modeling a little bit trickier to get right.

If this is your case, don’t worry. By collecting relevant external data from public records and analyzing market trends, your business can still make informed assumptions.

Financial assumptions are useful in helping you make business decisions. Nevertheless, getting too granular and detailed in your assumptions can over-complicate the financial plan.

A good model requires a certain amount of flexibility and should be modified as your company grows.

Now, let’s look at the different types of assumptions used in financial modeling.

Revenue Assumptions

Revenue assumptions are the foundation of most financial models. They estimate the future sales of your company and directly influence your income statement.

Accurate revenue projections will help your company make a budget, set sales goals and allocate resources.

Revenue projections help a company assess:

• Units Sold and Sales Mix: Estimate the total sales for a specific period and, if applicable, estimate the share of each product or service within the overall sales total. 
• Growth Rate: Project how big a share of the market your company will have and how much your customer base will grow over time. Assumptions can account for customer acquisition and retention rates.
• Pricing Strategies: Assess the prices you’re selling your products at and determine whether your strategies align with market conditions.
• Seasonal Patterns: Some businesses’ revenue fluctuates significantly throughout the year, either peaking or dipping during certain seasons or holidays. This can impact quarterly revenue projections.

Cost Assumptions

Cost assumptions account for the fixed and variable costs your company will incur to operate.

These assumptions help determine your company’s profitability, cost structure and potential areas for cost control measures.

Cost assumptions include:

• Variable Costs: Costs associated with the production of goods and services, such as raw materials and labor, that may vary throughout the year.
• Fixed Costs: These are the operating expenses that will stay the same each month or year, such as salaries, rent, utilities and other overhead costs.
• Inflation: Assumptions can help you understand how inflation will affect your company’s profitability and pricing strategies.

Growth Assumptions

Growth assumptions help your business plan for the future and can take into account any investments or expansions that your business plans to make.

Growth assumptions include:

• Organic Growth: Predict how much your company will grow through increased sales, market expansion or new product development.
• Inorganic Growth: Understand the financial growth that mergers or acquisitions will bring to your company.
• R&D Investments: Some companies will need to factor in their spending on research and development that will lead to new products and future revenue.
• Expansion Plans: Estimate the impact that opening new locations, entering new markets or launching new products will have on your company.

Working Capital Assumptions

Working capital assumptions are crucial for understanding the short-term assets and liabilities that your company needs to manage day-to-day.

Realistic assumptions help your company’s assets stay liquid, so you won’t run into payment issues.

Working capital assumptions include:

• Inventory Levels: How much inventory does your company hold relative to its sales? Too much inventory can be costly and create turnover issues, while too little inventory can lead to fulfillment problems.
• Accounts Receivable: Estimate the average time it takes customers to pay their invoices.
• Accounts Payable: Estimate the average time your company takes to pay your suppliers.

Financing Assumptions

Financing assumptions help you consider how your company will finance its operations and future growth. They can significantly influence your company’s cash flow projections.

Financing assumptions include:

• Debt Financing: Assumptions about future borrowings, interest rates and repayment schedules, all of which can restrict your company’s financial flexibility.
• Equity Financing: These assumptions can take into account shareholders’ impact on your company and the expected price of company shares.

Macroeconomic Assumptions

Certain external factors are beyond your company’s control, but you should still take them into account when financial modeling. External economic factors can have a significant influence on your financial performance.

Macroeconomic assumptions include:

• Economic Growth: Take into consideration your market’s growth rate, which impacts demand for your products and services.
• Interest Rates: Changing rates can impact borrowing costs and returns on investments.
• Inflation: Rising costs can affect both revenue and costs. Inflation assumptions can tell you about your future purchasing power.

Conclusion

Assumptions form the foundation of a strong financial model, using past data to forecast revenue, costs, and growth. However, it’s crucial to ensure these assumptions are accurate to avoid missed opportunities and financial setbacks.

Now that you understand how these assumptions impact your financial model, it’s time to put them to work.

Start building your financial forecast today and adjust it as your business evolves.

Unsure of where to start with financial modeling? Get the experts to help! Finvisor’s team of certified accountants can help your business create a financial model with accurate assumptions based on your company’s historical data.

We recognize that every business’s goals are unique, so we tailor our services to your needs to help you plan for the future success of your company.

Get in touch with Finvisor today!