A financial model is a very powerful, often underestimated tool to analyse various financial scenarios which a business faces. This is very useful especially in the present scenario, where entrepreneurs may have to try various permutations and combinations to try new strategies for their business. The utility of a financial model includes fundraising (debt/equity), mergers & acquisitions, decision making engagements, sale or divestiture of business unit, financial planning and budgeting, valuation of a business, etc.
A good financial model will contain input sheets, calculation sheets and output sheets, including a dashboard. A robust financial model ensures flexibility to the user to change the inputs and to isolate various factors to test its impact in a financial plan. It will also be transparent, so that any model user can easily interpret it and audit it to test its accuracy.
Here are 5 ways in which a financial model will be of help to an entrepreneur:
1.Discussions with investors: Financial model is an effective tool for fundraising (debt & equity). Once the organization has a robust financial model, it will come handy to convince investors regarding the future plans and growth of the business. Having a solid financial plan shows the entrepreneur’s confidence in the business. It helps the investor also to identify the various assumptions associated with it and its impact on the model. Moreover, some business plans may have to be altered after investment decisions are made. In this case also, a flexible financial model will be very useful to the entrepreneur, as he will be able to make the edits easily.
2. Internal budgeting: A robust financial model helps the business in financial planning and analysis, to identify the long term budgets and derive short term budgets. This is very useful in current circumstances, where it is difficult to predict the future revenue and profitability. This helps in identifying fixed costs which have to be incurred anyway and variable costs & discretionary expenses, which are flexible. Various budgeting initiatives can be taken, where discretionary expenses can be deferred to a period where the organization expects more cash inflow. Any variance between the actual and the budgeted can be analyzed in depth and corrective measures can be taken as required and relevant modifications can be made in the next budget. A good financial model also serves an input to MIS(Management Information System).
3. Strategic decision making: A financial model is a critical success factor for any business – irrespective of its size or stage. The importance of planning can never be underestimated. There are various ‘What if’ scenarios, which an organization encounters. E.g. if a new geography is introduced or a new service line is added or a new product is introduced where pricing can vary. A financial model clearly specifies the various critical assumptions to be made to understand the impact of each of the scenarios. This assists the management in making informed decisions. Many decisions made by the management are irreversible in nature and hence it is very important to test it initially with a financial model. This will be helpful to analyze various crucial decisions like own production unit or outsourcing, discontinuing a division, introducing a new product, etc.
4. Analyze sensitivities: In an unpredictable market, there could be various factors which can cause a change in the income or expenses or cash flow – e.g. increase in the quantity sold or a decrease in price for a new product, unexpected increase in capital expenditure, etc. By doing a sensitivity analysis, the management will be able to understand the best case, base case and worst case scenarios and take prudent decisions. A flexible financial model permits to carry out various types of analysis which are useful for the organization.
5. Ensure accuracy of the financial plans: By creating checks in financial model to cross check between various inputs, calculations and outputs, the model ensures accuracy of its results to a great extent by eliminating various logical errors. Quantifying the numbers makes it easily measurable and hence higher accuracy can be expected. If inputs can be provided in a prudent manner after performing necessary research, a financial model of good quality can be created.
They key ingredients to a financial model are as follows – (a) The purpose of the model should be well defined (b) It should give accurate results (c) It should be transparent (d) It should follow a logical structure (e) It should be customized to the needs of the organization (f) It should be flexible. While it is easy to create a simple financial model using MS excel, complex scenarios can be built in using VBA and various data analytics tools. It is very important to stress test the model before using it for any purpose. While there are various standard financial models available to help you with decision making, it will always be best to create a customized financial model for your organization, for the intended purpose.
Planning is bringing the future into the present so that you can do something about it now – Alan Lakein
The author CA.Deepalekshmi is a partner of JAKS & Associates and can be contacted at firstname.lastname@example.org or on +919895703046.