What Financial Model Is And Why You Need It
Have you tried raising funding for your start-up or been part of a standard fundraising process? Then you should know that a financial model is an unavoidable prerequisite. An investor can accurately determine how much a stake or percentage is worth with a financial model. This is necessary to determine the value of the company accurately. In other words, how much stake in your company can N5 million buy? This is one thing the financial model makes very clear.
Financial modeling is the process of building a mathematical representation of some or all aspects of the financial operation of a business. It is the primary way to build financial forecasts for a business. These models aim to help enterprises to predict the future financial performance of a company or project depending on its current earnings (as depicted in the income statement), revenue, balance sheet, and cash flow.
Financial models help test-run scenarios to identify the sensitivity of significant outputs and inputs. Although many large companies widely use financial models, many SMEs do not even know they need one until it is time to raise funds.
Still not sure about it? The following are reasons why you most definitely need a workable financial model for your SME.
1. It helps simplify business goals
Financial models help translate business goals into real figures. They clearly define where the business is now, where it needs to get to financially, and what it needs to do to achieve its objectives. Your first step requires building the model and setting clear projections and assumptions. After doing this, you should agree with all the relevant stakeholders. This allows those stakeholders to effectively measure their progress against the predictions the model has provided.
As with all business plans and projections, there is a need for management to use these projections to measure the progress of the business. When in place, they should not just be used to obtain loans or grants and then discarded to the back of the file. They should be part of the operation measurement process.
2. It is flexible and shows financial operations at a glance
One of the main advantages of financial modelling as a way to build financial projections is the flexibility that it gives the user. It contains three aspects that allow the user to look at the outcome of several scenarios ery quickly. Financial models can be built as precisely as possible and could be either monthly or yearly projections.
As time progresses, projections will be compared to the actual performance of the company. This is crucial feedback, especially for small business owners or start-ups that are not used to the planning or budget process. Advanced financial modeling in excel can also be fully functional and flexible, as you can build based on multiple cases (downside, upside, and base case) and make necessary adjustments as required.
3. Improve Employee Engagement
The process which the financial modeller will use when building the model will engage all the relevant employees of the business. This process itself usually helps those individual employees to identify issues or measures which they may not typically have noticed.
It helps each of them to own their responsibilities and buy into achieving the targets that they are responsible for completing. The process also identifies areas of concern, therefore enabling management to address these issues.
4. Improve Decision Making
A good financial model will be a key tool that the decision-makers of a business will use to make calculated business decisions. The financial model will provide decision-makers with the right information to make relevant decisions.
Proper measurement by management against the forecasts will highlight any area of the business that is not performing according to plan. This enables management to rectify the situation if possible or necessary.
5. Identify Risks or Cashflow shortfalls
A properly constructed financial Model will identify potential risks or cash shortfalls. With this, management can make necessary provisions promptly. Many growing businesses get into cash flow troubles if their business is growing faster than their financial capacities.
Externally, the business is doing very well. However, due to timing differences between money in and money out, the business can run short of cash. This will cause a huge strain on the business and stress on management.
Identifying this early helps elevate that strain and stress. Companies lower their financial risks by using financial models to evaluate their projects. With financial modeling, businesses can see the impact of marketing campaigns, the cost of entering a new market and the effect of price changes on the industry, amongst others.
