What is a financial model?
A financial model is a tool companies can use to forecast future financial performance. Generally, financial models are built within excel using formulas to make it easy to see how various manipulations can affect a business.
For example, if you were to increase sales your costs would increase by a variable rate, but so would your bottom line. Below is a brief description of some of the types of financial models that may be useful to you:
- Forecasting Model: In a forecasting model, you forecast what your business’s finances will look like in the future using predictions based on past and present data as well as trends you see in the economy and your industry. Many companies use forecasts to create a budget model for their business.
- Pro Forma Financial Statement or Three Statement Model: This model takes three financial statements (the income statement, balance sheet, and cash flow statement) and links them together in an excel sheet.
- Discounted Cash Flow (DCF) Model: Building on a three-statement model, the discounted cash flow model takes into account discounted cash flow to determine what the present value of the business is.
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Financial models can (and should) be built before any major financial business decision is made.
For example, a financial model can be built to understand how a merger, consolidation, leveraged buyout, or initial public offering would affect your business. For more complex models like these that are used for large business decisions, it may be best to consult an accountant or have your controller or CFO build the model.
Why are financial models important?
Financial models are important because they help business owners make sound business decisions on a quantitative level. Before a major financial decision is made, multiple assumptions can be tested within the model to give the business owner an idea of “best case” and “worst case” scenarios.
Of course, it’s impossible to predict the future 100%, but financial models can help you get closer to knowing what the future of your business will look like.
How to build a financial model?
You may now be asking yourself how you can create a financial model for yourself.
In order to save yourself the time of building a model from scratch, I would recommend using a free template from a reputable source like the Small Business Administration or one of their affiliates (SCORE, WBC, SBDC).
As an example, you can download the “PROFORM-MST” template, which is a template for the pro forma financial statement, at the bottom of this page. At first the template may seem overwhelming, but think of it as a color by numbers financial document. Simply go through each tab, row, and column and either fill it in with appropriate data (based on historical records or assumptions) or skip it. The formulas that exist within the document will work their magic to provide you with valuable information you can use to do quantitative analysis of your business.
What can a financial model tell me?
This may sound crazy, but playing with a model can actually be fun.
For example, you can think of “What if” scenarios to test in your business. For example, you can test “What if I raised my prices by $0.50?” To do this in the template mentioned above, simply fill in the “12 month cash flow tab” like normal, and then adjust your revenue to show an increased unit price of $0.50 (or any other amount that is appropriate for your business). Once this is done you’ll be able to see how one small change can affect your bottom line.
If knowledge is power then financial models are one of the best power tools in your business toolkit.
Just like any other tool, it’s important to practice until you feel comfortable with the tool and elicit feedback from experts when you’re first starting out. As mentioned before, the Small Business Administration and their affiliates are great resources, and if you didn’t know, they also offer free business consulting which can include assisting you with your financial model.