From psychics to astrology, throughout history humans have tried to see the future and businesses are no stranger to that drive. The decisions that determine success or failure are highly contingent on factors outside their control, ranging from future demand for their product/service to the actions of competitors. Unfortunately, the idea of a corporate crystal ball is a myth--no one can provide an accurate vision of a long-term future. Leaders will make their decisions based on the best available information, and they simply can’t know what will happen…but they can model it.
What is financial modelling?
Financial modelling can help estimate the impact of your business decisions under different conditions. To do that, a financial model will build a financial picture of the business itself as well as the market in which it operates. That picture can be as simple or as detailed as you need. For a simple model, you could use the high-level information found on historical financial statements, such as historical revenue growth, fixed vs. variable operating expenses, and balance sheet accounts as a percentage of revenue. For more detailed analysis, you can break that information down into its underlying parts and growth drivers and treat each item as an input. The level of detail will ultimately be determined by the needs of the business.
Once the inputs are set, you make a series of assumptions and then test what happens in various scenarios. As a simplified example, let’s say you’re planning to invest in new equipment that will double your production and you assume that you can sell at least 50 per cent of the increased capacity within six months. The model then evaluates what the effect on your business would be in different scenarios—what happens if you only sell 40 per cent in six months? What about 20 per cent? These considerations could drastically affect your decision to expand production.
Why use financial models?
According to Grant Thornton’s International Business Report, a rise in optimism among mid-market businesses is leading to a rise in plans to invest in themselves. Nearly half (45 per cent) intend to invest in new plants and machinery and 56 per cent plan to invest in technology. Analysing potential outcomes can help make those decisions and develop long-term plans. Considering what will happen under varying conditions years into the future can help to properly assess the potential risk embedded within your plans.
Recently, we had a client planning to invest $5 million to expand their operations and asked us to develop a simple model to see how the expansion might go. As we ran the model and stress-tested the underlying assumptions, we came to see that the only way the project would yield a positive return on investment is if interest rates were lower. The client ultimately decided to put the project on hold until rates improved. By doing their due diligence and analyzing their project, they saved themselves from a decision that could have threatened the health of their business.
Even if owners and managers are confident in their plans, sometimes investors and financial institutions will ask for more. A financial model can make it easier to secure financing by providing evidence of a project’s viability in the financier’s own language: numbers. Additionally, including models in a pitch to potential investors adds considerable credibility to your business plan and to you as a potential business partner.
What should be included in a financial model?
A financial model should at its core illustrate the financial statements—income statement, balance sheet, and cash flow statement—forecasted into the future. Often the user of the financial model can benefit from additional layers of information to help make high-level assessments of the underlying detail. Key performance indicators, graphic depictions, benchmark data and debt covenants are all value-added components that can take your financial model to the next level.
How can I begin using financial models?
While simple scenario planning and modelling can be done in a basic spreadsheet, professional advice will unlock the true power of a financial model. Identifying and testing assumptions, pulling together the right data and conducting a comprehensive analysis can be daunting, but our advisors can help guide you through the process.
