Sometimes, however, data is essential to back up your intuitions. A financial model is a great tool to help you make informed decisions. A financial model allows you to compare investment options, evaluate expansions, and gauge the impact of new growth initiatives on working capital, profitability, and valuation.
You’re more likely to be surprised and find yourself in a difficult place if you don’t plan for the potential pitfalls and opportunities of your business.
1. Make financial projections
Before you can do any financial modeling, make sure that you have a current set of financial forecasts. These are your projected sales, expenses, financial obligations, and commitments for the future. Spreadsheets make it easy to perform sensitivity analysis. This involves changing variables for different scenarios. For the coming period, projections are made for a company’s income statement and balance.
While many entrepreneurs fail to update or create their financial projections, they can help you manage the company’s finances. This is especially true if your company has inconsistent cash flow month to month because of seasonal fluctuations, lumpy receipts, or rapid growth.
2. Develop appropriate models
Now you can use projections to build financial models. To see the impact of business decisions, you can modify inputs to your projections. Modeling is useful for:
- Big deals
- New products
- A project to improve efficiency or make operational changes
- Investments in new machinery or technology, as well as hiring
- Raising funds
- Slowdowns in the economy or seasonal
It is a good idea to link all of your projections into one spreadsheet. This ensures data consistency and automatic application across income statements, balance sheets, and working capital documents. You can also break down your assumptions on a separate worksheet to make it easier to see and modify them. To summarize and visualize results more clearly, you can use tables or charts.
3. To allocate funds, use models
You can use modeling to evaluate the impact of a decision on working cash, revenue, financing, profitability, and valuation. It is also possible to compare potential investment returns and payback times. “You don’t want to go blind.” “The best surprise is not surprising.”
Modeling can often lead to surprising insights. Example of a company that prepared 10-year models to support three growth projects: a new product and two expansion options. The clear winner was modeling. Both expansions would have led to strong returns. However, the new product would have produced even better results with less risk and a longer payback period.
A model can help a company allocate scarce resources during times of uncertainty and financial stress. The expert was asked by a company with cash flow issues and insufficient funds to pay payroll and suppliers. The CEO needed to plan how much cash he would spend on the company and when. This was done by keeping a cash budget that was updated every week.
You can also model the impact of a new deal to help you avoid cash shortages. While you may need to pay workers or buy raw materials, the payment might not be due until six months later.
“Modeling will help you determine where your company will be stressed and how much funding you will need. It will also show the impact on your gross margin.”
4. Perform a sensitivity analysis
Many assumptions about the future can be wildly incorrect. It’s important to include sensitivity analysis in your models. This allows you to consider different outcomes and create a range of scenarios. You could include the most probable scenarios, optimistic and pessimistic, for example.
You can do this by changing key inputs like revenues, variable, fixed expenses, marketing, and inventory.
5. Hire the right person to help you
To create models, you may need special expertise. As your business grows, your bookkeeper might not be able to provide the necessary knowledge. As your business grows, complexity increases exponentially, and the stakes are high.
6. Keep Update regularly
Modeling should not be done only once a year. To see the impact on projections, you should always update your model when conditions change. Modeling is also useful when a new project or decision is being made. Expert states, “You want the future to be modeled all the time.”