Thursday, July 28, 2011

What is a financial model?

I recently posted an article about the importance of having a proper financial model. A friend gave me a valuable feedback, saying that the posting must be easier. Following his guideline, I will try to explain the definition and benefits of a financial model, so that 10th graders can understand. (A 10th grader who wants to know about financial modeling… is worth a LinkedIn connection for sure!)

A financial model is a forecasting tool. You put variables into the model, then it gives you back a forecast. It is called a financial model because the model gives back financial forecast. When you plan a business, you have basic assumptions about your operation. These assumptions are the input into the financial model. The model will return the expected result of your business in financial terms.

Let’s suppose that you have a business of selling Kryptonite rings to people who want some form of protection from Superman attack. You know what price to charge to your customers. You also have some approximation about the number of rings you can sell in a given time period. You know the costs of running the business. You put these variables into the model. The model will return the expected result of your business – in financial figures.

Why do you want to have a financial model for your business? There are two very important benefits. First, it will tell you if the business idea is worth the try. If the model says that you will go bankrupt in 6 months, you have to think it over. Either you should find a remedy that will save your business from going down, or you need to scrap the business idea altogether. In most cases, you will be able to find out a way to make your business worth the try, for example, by reducing unnecessary costs or securing more loans.

The second benefit is being able to get better prepared for surprises. Your business won’t fold out as you expected it to, because life isn’t designed that way. Things change. The business environment can change dramatically after a certain amount of time. There are simply too many things that are outside of your control. As a wise businessman, you have tons of “what if” questions. A good financial model will answer these questions.

Let’s suppose that the suppliers of Kryptonite sell the ore at higher prices. You know that your business will be affected in an adverse way, but how much? Your financial model will answer this question. You change the inputs, and you have different results. You can test how much adverse change in variables your business can stand. This is called a stress testing. You are much better prepared if you have plans for several possible scenarios. A good financial model will help you do this.

My advice is this: Go get a good financial model. With a small up-front investment of time and money, it will save you from many surprises in the future.

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