There is a fine saying by Sun Tzu: “know yourself, and you will win all battles.” In the business context, I cannot think of a more tried and tested tool than the financial model which spurs entrepreneurs to stay constantly updated with a 360 degree understanding of their business.
Do you really know your business inside-out?
What is Financial Modelling?
A financial model goes beyond a financial statement (you cannot manage what you cannot measure) and a budgeting exercise (you cannot spend beyond what you can earn).
Unlike a financial statement which is a snapshot of the present and a budgeting exercise which places a stronger emphasis on immediate future needs, a financial model is meant as a diagnostic strategic planning tool to secure your business’s longer-term future.
A financial model == financial statement or budgeting exercise
I would like to think of financial model as the numerical version of chess (underlined are similar benefits and attributes). At the starting line, you position various business drivers/resources and as the game unfolds, watches the situation from a bird’s eye view and deploy changes accordingly.
Ultimately, you reach your goal by understanding the inter-connectivity of available resources and stimulating various outcomes before determining the next move.
Below are some commonly received questions from past clients on how the financial modeling process works.
Five Commonly Asked Questions
How does financial modeling for business owners differ from other types of financial modeling?
The focus on financial modeling for business owners is more for business decisions – the aim is to help the business owner make as accurately as possible any material decisions to improve business profitability.
While assumptions related to the cost of capital and balance sheet strength are important to a loan banker looking to evaluate credit score of business client, assumptions related to profitability (i.e. revenue and cost driver) are the more important aspects of the financial modeling process for business owners.
How does financial modeling unveil insights for decision making? Can you walk us through via a real-life case study?
There are a few key components to the financial modeling process which forces business owners to consider their business workflow from various perspectives.
Consequently, fresh insights arise.
These components include but are not limited to: identifying business drivers, deducing cash cycle and deriving business valuation.
Zooming into identifying the business driver, let’s take a Chinese eatery for instance.
Factors affecting revenue generation including but not limited to space capacity constraints (consider seating layout), table turnaround, average spend per customer, average spending per peak/off-peak hour, takeaway hurdle (dependent on chef capacity).
Factors affecting cost include but not limited to: employee labor productivity, rental cost, inventory cost.
Some key revelations from the above that surprise our past clients include uncovering of certain popular menu items that might be underpriced and more economical sense to shorten operational hours (during the less active hours to reduce labor cost).
How do I determine my revenue model?
Broadly speaking, revenue is a multiplication of two components – price and volume.
For pricing factors, it is usually a consideration of:
1) Cost plus basis – what is the cost of service or raw material for the output
2) Market rate – what your peers might be charging
3) How aggressive a pricing strategy you might like to deploy
For volume, you may like to think about:
1) Top-down regarding maximum potential market size
2) Bottom-up approach via looking at your sales distribution channel capacity
Together these two approaches form the lower-bound and upper range of the total quantity playing field.
How often should the financial model be updated?
The rule of thumb is as often as you will need to make strategic business decisions.
I would say minimally on a monthly basis.
It is best if the information feeds in real-time.
Any recommendations for someone looking to get started on financial modeling?
1) Attend training/classes – the benefit is complete mastery and control over how you can maneuver it for your needs, and the downside is, of course, your time
2) Engage a consultant to help them through the process – it all boils down to consultant value to fee. A consultant can help you set up a tailored financial model structure, but it will only be valuable if you provide the input to the numerical assumptions
3) Purchase or source for existing financial model template – the benefit is you can get started immediately, but as is not your template, it will be challenging for you to modify it in your maintenance or to customize it more specifically for your industry