Financial modeling is an important part of any type of forward looking financial planning. Contrary to popular opinion, increasing revenue and returns is not as simple as “turning on the faucet”. In order for revenue and returns to follow growth, you’ll need to model out exactly HOW you’ll get there, tweaking different levers until you see the revenue where you want it to be.
What is a Financial Model?
Financial modeling is used to create a financial representation of the business at a future date. It is also a tool used in forecasting that relies on key assumptions to perform calculations and make recommendations based on that information. Good models are built out using varying assumptions, because of the somewhat unpredictable nature of forecasting. By modeling out the results of a range of values for each assumption, you can see if your business is on track to meet your goals, or if you’re headed for trouble. Models inform your financial planning, helping you to set better goals and reach them over time.
How to Use a Financial Model
Modeling can be used to do a number of things, depending on the assumptions and calculations you use. Here’s a good list of the top 10 types of financial models, though it’s in no way complete. While models can be used to value companies and options, they can also be used to help make key decisions in business, such as the decision to go public, or to open a new product line. They’re also helpful in deciding whether or not to acquire a company, or to expand to a new market. Depending on how you structure them, models can be extremely helpful in making informed business decisions.
Avoiding the Pitfalls of Modeling
While financial models can be very useful in forecasting and planning, the model is only as good as the one building it and the assumptions feeding into it. When building a model, be sure to avoid these common mistakes:
Pulling From Incorrect Financials
Because many models pull from the financial statements, if your financial statements are a mess, it’s probably safe to say that your model will be too. Be sure your financials are accurate and up-to-date before building a model that relies on them. In most businesses, this also requires appropriate controls and processes to be in place so that the model is correct going forward. Not sure where to start? Here’s an article that may help.
Building a Concrete Model
As with most planning and forecasting, it’s nearly impossible to get every aspect of a model 100% correct. That’s why it’s so important that models are living, breathing documents. As time goes on, assumptions change, and your business progresses, you can use your model as a template, adjusting the levers and assumptions as needed.Don’t make it too difficult to alter your assumptions and you’ll save yourself a ton of time by not building an additional model.
Trying to Nail Down One Assumption
Assumptions are the core of a model. Yet, while incorrect assumptions lead to incorrect recommendations, it’s extremely difficult to make an accurate assumption, especially as you model out farther in the future. Instead of trying to nail down an estimate, try to get a range of values for that particular assumption. Then, use the model to calculate the different outcomes for a few different values in the range. Modeling this way also gives you a set of expectations, should things go awry. Now that you’ve got a few different outcomes to work with, you can plan for the best and the worst.
Using Too Many Assumptions
The more informed your model is, the more information it can give you about the business. However, there is a point where using more assumptions doesn’t provide more benefit. Particularly in startups, it’s difficult to assume anything very far into the future, let alone making accurate assumptions for 20 different factors. Though it may seem beneficial to spend hours planning and calculating every assumption, Dave Chase suggests focusing on 5-15 assumptions that you can really hone in on. You’ll save time and get a more accurate model in the process.
Financial models can be effective tools for planning and forecasting. By modeling out revenue, businesses can more readily “turn on the faucet” and begin reaping the rewards.
Advanced CFO consultants are experts in modeling and forecasting. We offer the full suite of financial services, from CFOs to Controllers and Accountants. You can trust that your business is in the hands of seasoned veterans, ready to take your business to the next level.