Financial Modeling Approaches: Top-down vs Bottom-up

Financial Modeling Approaches: Top-down vs Bottom-up

  Adam Tzagournis, CPA · Founder & CEO · 3 min read

You’re on an investor call or in a board meeting and someone asks a question. It’s about the numbers. They want to know why you’re projecting 50% revenue growth if marketing spend is being cut. You don’t have a good answer, and you say you’ll find out and get back to them. You dig into your financial model, but can’t find anything to support a meaningful response.

This scenario is all too common. Financial modeling is a tedious, difficult task to get right. A convenient (but unsound) shortcut is to take a top-down approach.

Top-down

Key business drivers are disjointed from projected outcomes

Changing the model to show major revenue growth doesn’t increase marketing spend or payroll expense for new hires

Bottom-up

Key business drivers directly impact projected outcomes

Changing inputs for marketing spend, conversion rates, or new hires will impact projected revenue and expenses

Imagine you’re trying to project out revenue for the next 24 months. A model with a top-down approach would:

  1. Take last year’s revenue: $1mm

  2. Multiply by 50% growth rate to get $1.5mm in projected year 1

  3. Multiply by 50% growth rate again to get $2.25mm in projected year 2

But how did you arrive at that growth rate?

Because there’s no underlying logic to bridge actual and projected amounts, it’ll be hard to speak to the details of that growth (the timing, what level of expenses enable it, etc). There’s no ability to double-click on the 50% to see how you arrived there.

A bottom-up approach allows you to see the drivers of each projected output. Applied to the example above, the model would allow you to change inputs for:

  • # of new customers monthly, which itself is determined by:

    • # of prospects in contact with your sales reps, determined by:

      • Marketing funnel (more inputs on spend and conversion rates)

      • Outbound sales team efforts (more inputs on sales rep headcount and efficiency)

    • Win rate of your sales reps (stable or improves over time as they get more experienced?)

  • Contract size of new customers

  • Renewal and churn rates for existing customers

Why aren't all models bottom-up then?

In short: they’re hard to build.

Creating them from scratch isn’t easy: conversion rates change over time as your company matures, and each customer cohort behaves differently. It’s hard to link each moving part together correctly to ensure the model tells a cohesive story.

Financial modeling is a process that requires collaboration from various executives to validate key assumptions. Therefore, bottom-up models must also allow you to quickly change inputs and incorporate the latest actual financial results.

Worth the effort

A top-down financial model with naive growth projections doesn’t cut it; it’s missing the explanatory power needed for investors and board meetings. Projections from a bottom-up model are much more credible, and will prevent you from being caught off-guard with projections you can’t support.

If you’re interested in a robust, pre-built financial model for SaaS companies with a bottom-up approach, FlowCog can help.

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