09 Mar Financial Projection vs. Financial Models – Understanding the Difference
Two of the primary financial planning tools used by a company are financial projections and financial models. These two terms are quite common in business and are sometimes used interchangeably. Despite the misuse, projections and models, though intrinsically connected, are quite different.
Financial projections are predictions about the future performance of a company. Oftentimes, all three core financial statements are projected: the profit and loss (income) statement, balance sheet, and statement of cash flow. They can sometimes be based on the historic performance and current state of the company, while taking into account expectations and assumptions about future market conditions and business plans. Financial projections are typically presented in monthly or annual increments for the next three to five years or more. The key takeaway is that financial projections are static.
Financial models are dynamic, interactive tools, most often created in Microsoft Excel or through specific financial modeling software, that link together multiple variables for the purpose of viewing the mathematical illustration of different business scenarios. It allows you to plug in different assumptions and see how that will impact future results across all three financial statements and investment metrics.
While projections determine the long-term goals and expectations of the business, financial models help to make important business decisions. As an example, a revenue model within the financial model will show the inner workings of how the business will actually generate sales. Sales generation may be predicated on the number of salespeople, each with defined sales targets that they are expected to achieve. It may also include the amount of dollars spent through various digital marketing campaigns with associated customer conversion rates. Factors such as this, in turn, will generate financial sales projections.
One can see how financial models and financial projections are closely tied together, however, there are key distinctions that set them apart.
Financial projections are static. Once they are finalized, they do not change unless the entirety of the projections are changed. Financial models, on the other hand, are intended to be flexible and dynamic. The financial model is all about working through any number of potential scenarios to see what the impact will be on the business.
Financial projections are used to set realistic goals for a business. They demonstrate where a company believes it is going based on known or anticipated changes to the business in the future. It is about illustrating and quantifying the expectations of the business. Meanwhile, one of the main purposes of financial models is making decisions in real time by understanding how different decisions will impact future financials. In other words, will certain decisions cause a company to miss, meet, or exceed projections?
There is also a very notable difference in how these tools are used by outside funders. Two primary outside funders are lenders, such as banks, and investors. Generally speaking, lenders are mostly interested in projections while investors will be more interested in financial models which demonstrate the inner thinking of business making decisions. A lender’s main concern is how well the business has historically performed and whether they will be able to pay back debts in a timely fashion. Financial projections, paired with historic actuals, are one of the clearest ways for lenders to make this determination. Investors will also want to see projections but models are typically used when presenting to them. This is to allow the financial outcomes of different assumptions to be reviewed, such as those relating to the impact of an investor’s potential stake in the business.