Most clients I talk with don’t realize that financial modeling is usually just a financial tool that is created in Microsoft Excel. When I first bring up modeling, most tell me their business isn’t sophisticated enough to warrant modeling.
In this article, we’ll discuss what modeling is, why you might want to create a financial model for your business, and some best practices.
At its’ basic level, a financial model is a forecast of a business’s financial performance using strategic assumptions. Let’s unpack what that means a little more.
Just like a weather forecast, a financial model attempts to forecast the future. The result of a financial model is usually a projected balance sheet, income statement, and cash flow for a future period, typically three to five years. When I build models, I also like to project key performance indicators that may be relevant to the business.
The magic of the financial modeling process is setting up a spreadsheet so that you can alter your assumptions. A financial model is a tool that can help a business owner determine the best strategic path to pursue. We’ll walk through some specific examples below of how a model can impact business decisions.
Financial models are built by analysts, banks, accountants, and several others. Most are made for specific reasons. Within most businesses, an accountant or outsourced CFO is typically responsible for building and maintaining models.
Why Create a Financial Model
There are several reasons that a client might ask their outsourced CFO to create a financial model. The result of a financial model is used for decision making and performing financial analysis. Inside a business, an owner will use financial models to make decisions about:
- Raising capital/debt
- Purchasing a new business
- How to grow their current business
- Budgeting or forecasting
- Valuing a business or segment of a business
Here are two different scenarios where I regularly create financial models for clients.
Modeling for Franchise Systems
I work with a fair amount of franchised concepts, and one of the first tasks I tackle is creating a financial model. Going through this process is extremely beneficial for franchisors and one they often remark they wish they would have done years early.
The first benefit the modeling process provides for franchisors is clarity on which processes they are doing that create value for their business. During the process, we often find many expenses that are not creating value and are wasteful. After we are done, a franchisor has a good idea of why each of their expenses are needed. They also have a good idea of what the metrics are that their franchisees must track and achieve to be successful. For instance, what does their return on investment (ROI) for each marketing dollar spent need to be? Once a franchisor knows that and other relevant indicators, they can start putting together a more thourough strategy.
However, the most significant impact is this process gives the franchisor confidence during their sales process. This process provides a franchisor has an in-depth knowledge of startup costs, expected first-year earnings, and the different inputs that drive value. Afterward, their sales conversation had with prospective franchisees become much more powerful. Too many franchisors don’t have this knowledge during their sales process and end up having sales conversations that not impactful. Most larger brands they are competing with do have this knowledge, and it shows to prospects.
Modeling for Investment
When a company is looking for outside investment, modeling is a requirement. Potential investors require to know the overall projection. They also want to know what how the additional investment will be spent.
Recently, one of my clients was getting ready for a capital call. This client had a group of five investors, who all had a more than an average level of sophistication. When the CEO floated the idea of a capital call to one of the investors, they mentioned they would like to see what the investment was going towards and what the overall impact would be.
This request was great because we had the answer. We knew that the company needed a new piece of machinery due to a bottleneck they had to workaround. Also that there were additional marketing resources required to get to the next level. We were able to create a model that showed the impact the investment would make on the company operations and results.
Modeling Best Practices
Model all financial statements
A lot of models I see stop at modeling just the income statement. This is a mistake. By not modeling out the other financial statements, there is not a way to accurately show the cash flows for the company. Further, several key ratios can only be done after the balance sheet and cash flow statement have been modeled.
Include Notes
Formatting is important, because a messy model is hard for the end user to interpret. However, notes should be include, especially around significant assumptions. There have been several times that I reviewed a model and wondered why a particular assumption was made. Because of the lack of notes, no one remembered why.
Show Your Work
A lot of models require complex calculations. For instance, I just completed a model for a client that I work as an outsourced CFO for that had over six different types of revenue contracts, each with different price escalators, and that would begin on different dates over three years. Each contract had significant inputs to determine revenue. To show the client how the calculations were being done, I needed to show my work so they could see what was driving revenue.
Financial Models are not Rocket Science
Hopefully, this article has given you a little more comfort around what a financial model is. While I certainly wouldn’t recommend that your bookkeeper build your model, you shouldn’t fear the next time you hear someone talk about doing some financial modeling for your business.
I am biased, but I genuinely believe a financial model is one of the best tools a business owner can have. When we do our strategy work with clients, it almost always culminates in a modeling exercise. Hopefully, I have convinced you that building a model for your business is a process that should be high on your list.
About Krieger Analytics
My name is Matt Krieger, and I am the founder of Krieger Analytics, an accounting and virtual CFO partner for small businesses and franchisors. Our goal is to completely outsource your accounting department from bookkeeping and taxes to virtual CFO advisory services. I am also the owner and franchisor of a concept called Monkey Bizness, in Denver, Colorado.
As a small business owner with a background in finance and strategy, I realized the benefits that a CFO could bring to smaller organizations. Most franchisors and small business owners don’t have a need (or budget) for a full-time CFO or bookkeeper. To better fit my clients, Krieger Analytics is a part-time resource. While most think of virtual CFO’s being involved in finance and accounting (we are), we are also involved in much more. We partner with clients by coaching, giving them clarity into their business, and creating growth strategies. Conversations are free, so don’t hesitate to reach out to me at matt@k-analytics com.