A financial model is simply a tool that’s a built-in spreadsheet such as MS Excel to forecast a business’ financial performance into the future. The forecast is typically based on the company’s historical performance, and assumptions about the future, and requires preparing an income statement, balance sheet, cash flow statement, and supporting schedules.
As a business owner instinct alone is not enough you need data to back up your instincts. A financial model is a great tool to help you make informed decisions. A financial model allows you to compare investment options, evaluate expansions, and gauge the impact of new business growth ideas and projects compared to your working capital, profitability, and valuation.
In order to be predictive and mitigate risks in your business, it’s ideal to periodically review and plan for your future using your financial models so as to leverage your opportunities while mitigating against a business crisis.
“The future depends on what you do today.”
Key Aspects to look out for in financial modelling:
Prepare your Financial Projections
Before you start off on your financial modelling journey, make sure that you have a current set of financial forecasts, then create estimated projections of your sales, expenses, financial obligations, and commitments for the future. Spreadsheets make it easy to perform sensitivity analysis. this can be done by changing variables for different case-based scenarios ideally this is done for the company’s income statement and balance sheets and working capital for the coming financial period i.e 12 months 1 year.
As an entrepreneur, if your business doesn’t have consistent cash flow month to month it is ideal for you to prepare financial models so as to plan and manage your finances and cost of operations because of seasonal fluctuations, lumpsum receipt of cash and spurts witnessed in growth of your business.
Create the model layout and design
It is therefore ideal to use the projections to develop your financial models. The idea is to have a tool that guides you to change inputs in your projections and be able to see the result or impact of your business decision.
Financial models are used to enable you to make the best possible decision in your business. Some of the uses include:
- Signing on new or big clients /deals
- Resource mobilisation and fundraising
- Change in operational process or productivity-focused project.
- Starting a new product line
- Acquisitions and mergers
- Expansion to new markets.
- Investments in a new team, technology, machinery
- Slowdowns in the economy or seasonal market fluctuations
It’s critical to structure a financial model in a logical and easy to follow the design. This typically means building the whole model on one worksheet and using grouping to create different sections. This way it’s easy to expand or contract the model and move around it easily while ensuring data consistency and application across income statements, balance sheets and working capital. It’s ideal to break out your assumptions on a different worksheet so as to be able to create variations and easily see them. Incorporating tables and charts are useful for easy interpretation of your data.
Use models to guide you on your fund allocations.
You can use the models to review the impact of a decision on your working capital, valuation, profitability, revenue, and financial need.
Modelling can often lead to surprising insights. Example of a company that prepared 5-year models to support three growth projects: a new product and two expansion options. The clear winner was modelling. Both expansions would have led to strong returns. However, the new product would have produced even better results with less risk and a longer payback period.
A model can help a company allocate efficiently scarce resources during times of financial uncertainty. For example, if a company with cash flow issues and insufficient funds to pay payroll and suppliers need to plan how much cash would be available to spend on the company and when. This can be done by keeping a cash budget that is updated every week
You can also model the impact of a new deal to help you avoid cash shortages. While you may need to pay employees or buy materials, the payment might not be due until three months later. Therefore modelling will help you determine where your company will be strained and how much finances you will need. It will also show the impact on your gross margin.
Keep updating it regularly
Modelling should be done as soon as your business conditions or processes change. To see the impact on projections, you should always update your model to factor in the change in process or business aspects. Modelling is also useful when a new project or decision is being made.
Perform a sensitivity analysis
Many assumptions about the future can be wildly incorrect. It’s important to include sensitivity analysis in your models. This allows you to consider different outcomes and create a range of possible scenarios.
You could include the different scenarios i.e. most probable, best-case scenario, and worst-case scenario. You can do this by changing key inputs like sales per client, revenues, the number of staff, fixed expenses, marketing, accounts receivable and inventory.
Hire the right person to help you
To create models, you may need specialised expertise. As your business grows, your accountant might not be in a position to provide the necessary support. As your business grows, complexity increases exponentially, and the stakes are high.
Reach out to us should you need support in modelling the future for your business!
K. Wahome & P.Wakesho