Financial modeling is perhaps best known as a technique used by Wall Street investment banks to anticipate performance of their investments. A financial model is a spreadsheet (sometimes a series of spreadsheets) that serves as a financial representation of a company.
A model incorporates formulas that calculate how the company might perform under a certain set of circumstances. For example, a model could be used to show how a proposed merger of two companies would stack up against other industry competitors in terms of estimated sales revenue, market coverage, expenses and profitability.
Benefits of Financial Modeling
Business owners often use financial modeling to explore “what if” scenarios and their likely impacts on the company. For example: What are the possible effects of opening stores in a number of new locations next year? Modeling can help you estimate the outcomes for a best case scenario, a worst case scenario and the most likely scenario. The business owner needs to see a range of likely outcomes to determine if the required investment is worth risking, given the range of potential rewards.
Perhaps your business has a new product under development. A financial model can help you decide whether to acquire new equipment to manufacture the product in-house, or whether it is more cost-effective to outsource the manufacturing process to a reliable vendor.
The financial model could also take account of likely timing and cash flow considerations. Outsourcing the manufacturing function perhaps means an earlier first product shipment date, accelerating cash receipts from product sales. In-house production requires an initial cash outlay related to purchase and installation of equipment. Estimate additional costs and time for training employees to use the new equipment and testing the first production run for output quality. Finally, the model can predict how soon product sales materialize under the in-house scenario.
Predictive Modeling for a Range of Time Frames
Financial modeling is not just used by companies that expect merger activity, new product developments or other big changes. Often an owner simply needs to envision a company’s financial future, assuming a variety of possible growth rates and a range of time frames. A business owner may want to see annual growth rates of 2, 5 and 8 percent applied to the next quarter, the next year and the next two years.
Until you run the numbers through a financial model, it’s difficult to understand how different the company would look after two years of 8 percent growth vs. two years of 2 percent growth. The output from this kind of modeling helps a business owner comprehend the range of outcomes and therefore make informed decisions. Sometimes just seeing what is possible inspires an owner to develop plans for achieving goals previously considered out of reach. Building a model also gives the business owner and management team a chance to question some of the company’s ongoing practices and see if there are ways to improve.
If you have never used financial modeling to help manage your business, give it a chance. You may find it inspires you. Click here for some tools to help you.