Why people who are hesitant to embrace financial modelling quickly turn into converts
Financial or business modelling is about being able to document and articulate the aspirations you have for your business. It’s about showing you understand how your business makes money, how it can grow and how it manages cash. Crucially, it allows others to understand this story.
Lots of people don’t feel comfortable with spreadsheets or think modelling is only for accountants. But sceptics we’ve worked with typically end up loving financial models and changing their view of the value they provide.
In this post, I wanted to explain why they’re so powerful.
How do financial models work?
A model, sometimes called a financial or scenario plan, is typically built on three key areas:
It has an “input” section that shows your key business drivers (sales, growth, pricing, conversion, churn etc.) and allows management to play out different scenarios by adjusting these drivers
These drivers feed into three integrated schedules – 1) a profit and loss account, 2) a balance sheet and, most critically, 3) a cashflow forecast
It may also have bespoke models relating specifically to your business (eg. “how long before my sales resource delivers the required return?” or “how do I price a product or SKU to deliver a margin of X%?”)
In other words, if you alter a driver such as sales it will show the effect of this in the profit and loss account (including adjusting your cost of goods sold to show margin), the balance sheet in debtors and the cashflow in terms of when customers pay those debts.
What should a financial model tell me about my business?
Models provide information that’s key to running a business effectively:
Gain insight into the impact of decisions, allowing founders and managers to look before they leap
Use assumptions to understand how profits, cashflow, valuation and shareholder returns change
Play out various commercial scenarios including helping assess whether shareholders should stay or leave their business
Determine valuations to support all aspects of investment and pitching, and underpin (S)EIS and all types of fundraising, including CBILS.
Capture the historical performance of the business and explain patterns of growth
Compare changes in unit economics, KPIs or other key metrics that underpin third-party valuations
Show how the timing of introducing new resources affects cashflow. For example, bringing in new sales resources ahead of future sales cash receipts
Three common forecasting scenarios
There are lots of complex questions you need to answer to build a business, so let’s start with three scenarios we’ve had in the last fortnight.
Scenario one: Preparing to sell your business
There’s a ton of information a buyer will need (without this there will be no deal) and a series of things a buyer expects you to know. Every question that you are unable to answer will undermine the confidence a buyer has in the opportunity and reduce the likelihood of a deal and/or the value of your business in the eyes of the buyer.
These are some of the common questions we come across that a model can help you answer.
“Can you give me a balance sheet, so we can understand the business?”
“This transaction’s going to take some time. How much cash runway do you have?”
“What overheads are fixed and what’s variable?”
“Can you break your revenue line down and the gross margins for each product line?”
“How are you justifying the assumptions in your forecast?”
“Describe how your business achieves growth. What resources does it need to do this? What are the timings of this resource?”
A sound financial model will allow founders to get ideas out of their heads, demonstrate commercial viability and stress test their intuition and commercial assumptions. This prepares you for those tricky buyer conversations and helps you feel more confident in negotiations.
Scenario two: Getting seed investment
Investors ask challenging questions to understand an opportunity and make sure founders understand their business. Modelling gives you the ability and confidence to answer those questions.
“How much money do you need? What will you spend it on? For what return? And based on what valuation?”
“What are the key assumptions in your model?”
“What’s the cost of acquiring customers versus the lifetime value you get from them?”
“What’s the reorder rate and your churn assumption?”
Forecasts don't remove the risk, particularly in a start-up, but proper modelling makes you appear professional and helps you tell a convincing story.
Scenario three: Launching new products
You’re about to launch three new SKUs of personal care products. How does the timing of their launch impact your cashflow? How much stock do you need, what’s the lead time for ordering stock and how long do you need to hold on to it?
Remember holding stock ties up cash and this may affect your ability to invest in key resources or spend money on acquiring customers.
There are a lot of factors that impact gross margins too and it’s really important to have a handle on your sale price (remember discounts!) and the cost of sales. A simple product like a bottle of shampoo can include differently sourced and priced components, packaging, picking and packing, distribution, postage and possibly export fees.
In product businesses, the relationship of value of stock held to gross margin to cash is critical and if you grow you will soon require a stock ordering cashflow model. This means the board can predict (and adjust) the order levels and understand the impact on cash and gross margin. If you grow quickly and do not have this control, you risk running out of cash – and this happens all too frequently.
I can replay versions of these three scenarios across most businesses that are trying to start, survive and grow.
Communicating forecasts to your team
It’s useful to share high-level data from your models with your team. It shows people that aspire to be in a successful business the opportunities and difficulties. You can also get feedback and ideas on how to grow the business.
Models allow people to understand the levers of growth and the impact on cash and profits if we change one or more levers, eg. sales price, gross margin, debtor collection times, reorder rate or churn. This process is key to creating sustainable growth in a business.
Board meetings are never just about going through management accounts (this is historical analysis). Financial modelling means you can look at the future, run different scenarios and evaluate potential outcomes. They present an opportunity to think strategically and plan for tougher times.
For example, I might present five different “cuts” of modelling data: base case, no change, raising two different amounts of investment, the impact of opening an overseas office and increasing the salesforce. Having a model allows you to see the impact of those decisions.
Similarly, models can help business owners who want to understand their options. The owner of a business with say £5m turnover and £1m net profit might have several options over the coming years:
Work in the business as normal
Exit the business in say three years’ time to realise capital and perhaps ‘derisk’
Go for growth, hunker down, split the business
Expand overseas
Step back and take a different role
That can be built into models with switches we can turn on and off to see the impact these decisions have on the business and, ultimately, owners and key team members.
Getting into good habits through modelling
You’re trying to bring predictability, repeatability and accuracy into your business. Modelling helps with that.
Using a CRM model to build sales forecasts and being more accurate about what’s coming in makes your profit and cash more predictable. It forces you to think about getting stronger, more predictable sales, which has to be good for the business.
In the beginning, these assumptions might be just that – your best guesses. But that’s okay because it provides you with a starting point to learn from.
Modelling is really about being able to make better decisions and articulate them, so people buy into and support these decisions. It enables you to talk about your business in a way that people understand.
There is a fear of modelling – my colleagues at Realise will testify to my hesitation when we started over a decade ago. But, if you can embrace modelling, it really does drive performance.
Simply put, you can’t scale and control a business that doesn’t have detailed financial modelling.
Financial or commercial models are a bedrock of the Realise journey methodology and we believe are fundamental to increasing the odds of your success. Quite simply, they are a tool that improves the quality of all business decisions. Whether you are looking to raise finance, buy or sell a business, assess strategic options or just business plan, you are going to need a model or forecast.
Are you facing business decisions that you think modelling could help? Want to talk through your options? You can book a 30-minute exploratory chat with me here.