In part one of this blog, I introduced financial modelling and how it could help your business. Now I move on to the important qualities of a good financial model.
So, what makes for a good Financial Model? No two financial models can be exactly alike, and one size fits all does not work in our experience. Every single business, big or small, successful or struggling, demands a comprehensive and unique approach to financial modelling. Often, the financial model developed one year for a business needs a complete re-assessment to meet the demands of new market opportunities, changing environment, or changes in financial conditions the following year. Flexibility is a fundamental element in the design and construction of a robust, dynamic financial model. No matter how sophisticated the model, the key focus should always be on the most sensitive yet obvious inputs, e.g. Units Produced, Market Demand, Revenue, Profit, Cash Flow, etc.
Is building a Financial Model an ART or a SCIENCE? Very simply, it is a mix of both. HOW something is presented is equally important as WHAT is presented, and this holds true with financial models as well. The author needs to understand the audience. For example, many business owners prefer to view results in a graphic format, while others are more comfortable viewing tabular results or columns of numbers.
Just a few carefully chosen factors can tell us most of what we need to know initially. This is why dashboards have become so popular. Using Pareto’s 80 / 20 rule: 80% of a business’s turnover is often driven by only 20% of its business activities. The trick is identifying which factors are the critical 20% and then building a dynamic financial model that enables the user to easily change the data relating to these factors.
What are the common mistakes to avoid when building Financial Models? There are quite a few:
- Misunderstanding / Ignoring cash: Revenues and profits are not cash. Only cash is cash. Most businesses fail because they forecast only revenues and profits, not cash flow. A very profitable company may be forced out of business if it runs out of cash.
- Lack of bottom-up detail: Forecasts need to be built bottom-up, i.e. details such as when to expect sales, when to hire employees, when to pay suppliers, need to be considered. Round numbers – like £100k in overheads in Year 2, £200k in Year 3 – are a sure sign of not having a bottom-up model, which distinctly increase chances of business failure.
- Unrealistic assumptions: Key assumptions need to be realistic, particularly if the purpose of the model is to attract funding. Projecting huge growth in revenues or profits is never a good idea if your business cannot support it. It wastes time and compels you to make decisions that will have long-term negative impact.
- Missing key financial statements: These must be prepared — Income Statements, Balance Sheets, and Cash Flow Statements. It is common to project out three to five years into the future. Of course, nobody can see five years into the future, but the model must convince that it is thought through and backs up important assumptions.
- Scenario and Sensitivity Analysis: A good financial model must include scenario and sensitivity analyses showing how projected results change if assumptions turn out to be incorrect. This allows the user to identify the assumptions that can have an effect on future performance ensuring continued focus on important business drivers.
In conclusion, having a robust, sophisticated financial model is absolutely essential to the success of your business. It is your financial road map. If the model is designed well and then updated frequently to reflect changing assumptions and market conditions, the path to success will be clearly visible for your business.
So, if you don’t yet have a robust financial model for your business, approach us to get started on one right now. You can’t change the past, but you can impact the future—and having a well-designed financial model is one of the best tools to ensure that you get an insight into your business’ financial future.