A financial model is like a control panel of an airplane or a map of a hike, in fact – “player» scenarios for developing your business. An effective financial model will help you find new growth points and increase revenue.
What is a financial model and why does a business need it?
A financial model is a forecast of the financial strategy of a business as a whole or its individual areas. This will help identify indicators that will have a greater impact on future earnings.
Depending on the goals and users of the financial model, its content with some indicators changes:
- for the investor – the emphasis is on return on investment and profit;
- for domestic consumption and forecasting development scenario – to find growth points and planning for future periods;
- for banks – to show sufficient funds to cover all future payments on new loans.
Everything is in order
Experts often jokingly say: “First we will be rich in Excel, and then in reality.” To ensure that the reporting data is not divorced from reality, you must first understand the method of forming a financial model. For example, an entrepreneur faces an ambitious task – to increase X2 income through a financial modeling tool. What should we do?
Analysis and predictions
We always start with basic values and scenarios – imagine what would happen if you left everything like this.
So, you take all the real data from the income statement, cash flow statement, balance sheet and other analytical reports, the depth of which depends on the analytics you have collected in your business. Then you only broadcast all the signs of future times, as if the dynamics of development and improvement or change remain at the same level. If you, as a trader, are not encouraged by this forecast, then proceed to the next point.
Look for growth points
We look for growth points – that is, we determine how it is possible to increase revenue and net income. If you have an action plan, then it is best to calculate it for future periods, taking into account the inputs you have: the number of supplies, the new average bill, new changes from implemented events, etc.
If there are no such ideas, then you need to generate them and write an action plan for their implementation, and then calculate your financial model taking them into account. It turns out that in your financial model you change each of the indicators and see what financial results you can get from implementing the improvements you plan to implement.
Different events have different effects. Your task, if you are interested in growing two times or more, is to find the most effective implementations, the implementation of which will have a greater impact in the form of net profit.
For example, by setting a goal for the sales department to increase conversion by 1%, in the financial model you will see an increase in revenue and an increase in net profit by a greater percentage, for example, in 5-10%. Or, by creating a way to change the average fee by 10%, you will get a greater impact by increasing the profit of your business.
Think about what is more effective for your business, for example: renting a car for delivery or using the services of transport companies. Or evaluate how changing the employee motivation system affects the financial situation: what is more effective – salary or percentage of sales, marginal profit, etc. in different hypotheses.
Understand if goals are achievable
Then it is very important to evaluate if the goals and planned activities are achieved. The financial model of the project will help you calculate what resources are needed to achieve it: for example, how much will it cost you to hire new staff or buy additional capacity, how much credit is needed which can be obtained to ensure supplies of the required volumes – all this must be calculated.
There are no cash gaps
Cash flows should be planned in such a way that there are no cash gaps during the planning period. If you see that there are months with a negative balance, then write an action plan for new agreements with suppliers to reschedule payments/delays, change the supply plan, or consider about refinancing existing loans.
The financial model can be many and multivariate, but it allows you to track the relationships between business indicators. Subject to change the others indicator in the table of the level of the sales funnel and see exactly how it is reflected in the net profit for the period.
By playing the table indicators in this way, you can see more clearly what exactly and how it affects the income: the cost of materials, the conversion rate or the number of visits to the site, and which of the actions that bring the biggest impact, so you can focus on what’s important.
Two methods
When building a financial model, one of two methods is used. You can start planning using a top-down approach – starting with the planned sales volume and the corresponding cost share and estimated net income.
Or you can do it “from below”. Then you, as the owner, “order” the desired net profit and all activities are thought out based on it – the necessary sales volumes, conversions, etc. are already calculated.
Recommendations and lifehacks
To ensure that your calculations are not separated from reality, use the following recommendations:
- Form development scenarios, but do not think in an overly pessimistic way and at the same time do not make overly rosy predictions that do not correspond to the market capacity of your niche. For example, in terms of financial models, I see sales volumes that do not yet exist in this product category, and the market itself in this category is stagnant.
- The goals of the company must fit the model built: if you sell only high-quality products, there is no point in calculating cheap parts and low receipts.
- The initial data for the construction of a financial model should be based on verified real data, and not “from the head”.
- When implementing your strategy, always check the calculations you plan in the financial model, otherwise it is a “dead” tablet on which you practice counting. Plan-reality analysis helps improve planning accuracy and keeps you from deviating from your goals.
In any case, no truly successful business is built without a financial model. It allows you to assess the company’s development prospects, identify potential risks and opportunities for growth. And most importantly, a working financial model allows you to quickly achieve the desired result.