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 10^th graders can understand. (A 10^th 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.

Entrepreneur, you need a good financial model

What does it take to make a successful startup? Idea, of course. Entrepreneurial spirit, whatever it is, also counts big time. Cash, for sure. I would like to add: You need a good financial model, as well.

A financial model serves two very important functions in a business at its initial stages:

1.      It proves the financial feasibility of the business model.

2.      It attracts investors.

The first function is the raison d’être of a financial model, especially at the beginning stage of the entrepreneurship. You know the business idea, and perhaps also ran some back-of-an-envelope calculation several times already, with good results. But hey, you are neither fast nor comprehensive enough to skip a computer calc session.

I have an episode. A friend of mine was planning a new start-up. The business idea sounded so good that I wanted to pour what money I had into the business if I could. Still, I wanted to test the financial feasibility of the business model, and volunteered to run a model for him. Voilà. The business could yield a whopping 150% ROI in 4-year time span if everything turns out as desired. But the financials stood on very precarious conditions. For example, if the SG&A goes up by only 20% (which is very probable in many occasions) the business was projected to wreck in the second year due to cash crunch. Another very important finding through the pro-forma analysis was, the investors in the second year could easily give up the idea of putting their money into the business, because they need to be under severe penalty in equity distribution compared to the first-year investors, who naturally require higher portion of equity to get compensated for proportionally greater risks. I recommended him, first, to reduce operating costs in the first year as much as possible, and two, to try to get all the necessary investment in the first year, so that he should not face the dilemma of attracting investors with dog pooh. As can be seen in this case, you never know for sure, until you run some real cold hard calculation.

The second function of a financial model is attracting investors. Think about it. A few simple line charts and pie graphs make a dull business plan look much snappier. Looking cool, believe it or not, is better than not looking cool in any aspect of life, including the 20-minute session you will be presenting to readily distracted would-be investors. But more importantly, shrewd investors seek solid information. The simple fact that you ran scenario analysis to prove the financial feasibility of your business idea, is a proof that you are not another guy next door with a run-of-the-mill idea from nowhere. Of course, they will also try to check whether your calculation is sound. This is also what you want them to do, unless you are trying to run a well-tuned scam.

One very noteworthy side benefit of building a financial model is getting to know your business better. Building a financial model requires a lot of discussion between the consultant and the entrepreneur. This naturally leads to reflections and deep thinking about your business, which will enhance and deepen your understanding of your own business and the business environment, which can lead to valuable insights on how to run your business.

The conclusion: go get a financial model. The small investment of time and money up-front will save you tons of troubles in the road ahead.


P.S. I can help you! Click the logo below and visit my site. I am providing free financial modeling service to start-ups and SMEs.