What Is A Financial Model?
A financial model is a document that helps you measure what you’re currently doing, and make predictions about the future.
It should not scare you – it’s just a spreadsheet that tracks how your money is made and how it gets spent.
The process might reveal some weaknesses in your current business/idea, or more accurately, it reveals weaknesses in the combinations of decisions you’re making.
The problem won’t be the spreadsheet; it will be that you’re not making enough money or are spending it too quickly.
I think of a financial model as being like a Dexa body scan.
This is where a fancy scale tells you all sorts of information about your body.
We’re used to seeing our weight in kilograms, but a Dexa scan breaks it down into percentages of bone, muscle and fat.
That’s a very useful distinction, because when most people talk about “losing weight” what they really mean is “lowering my body fat”.
They’d happily lose 5kg of fat and add 6kg of muscle, even though that’s technically “weight gain”.
Dexa scans tell us a better story about how we’re tracking, making it harder to delude ourselves.
They can also detect issues that haven’t yet become apparent, like losing bone density.
Here’s the thing: if you get a scan and don’t make an action plan, nothing good is going to happen.
Numbers without strategies become trivia.
What matters is that we see the “As-Is” figures, then devise ways of making improvements.
A Dexa scan might prompt you to lift more weights or eat less sugar.
Similarly, a financial model might prompt you to raise prices or form new partnerships.
In both scenarios, the key is the combination of clarity, action and re-measurement.
This allows us to see our progress and inspires us to keep making good changes.
Crash Test Simulations
I also think financial models are like crash test simulations.
While a scan measures the situation today, a simulation tells us what would happen with a few modifications.
For example, a crash test might reveal what happens to each part of a vehicle in an accident, so that designers and engineers can keep passengers safer.
They can modify the vehicle, put in a new dummy and run the simulation again, measuring the results.
This also allows each manufacturer to visually prove that passengers will be safe in an accident, earning them a higher safety rating from independent reviewers.
With our financial model, we can play with “What If?” scenarios to see what could happen:
What if we launched a new product?
What if we served a new type of customer?
What if we tried a new business model?
What if we growing the team?
What if we open a second store?
We can also find the breaking points of each model; the amount that sales can drop before the business no longer makes a profit.
This lets us pick which plans make the most sense, highlights the flaws that could sink the business, and lets us answer investor questions about the future.
Here’s what typically happens:
An entrepreneur sets out to create a profitable business, knowing that they can use their profits to do great things.
This is the kind of planning that happens with whiteboards, coffee, paper and red wine.
They then go out into the real world and start the business.
They make a bunch of sales, and spend a lot of money to make sure their customers and staff are happy.
A year later, they tally up the numbers to see what’s left over – the profit or loss.
This is the by-product of the business, usually an unimpressive figure.
I’ve seen this happen a lot, and the common theme is that nobody accidentally makes a profit.
Profits are something that has to be designed for; you need to plan what margins you’ll charge and then defend them from the inevitable wave of good things to buy.
Mike Michalowicz has a good book called Profit First.
It describes a philosophy/system that sees businesses periodically set aside a predetermined profit amount, so that it can’t accidentally get spent by the business.
He argues that there’s always going to be a list of things to spend money on, and if you’re not careful it’ll eat up all of your profits.
By removing your profit at the start, you’re forced to be creative with your costs, not your margins.
This is why social enterprises need a way of tracking their numbers – if you fly blind, you’ll end up with no surplus cash at the end of each year.
Naming Your Assumptions
“It ain’t what don’t know that gets you in trouble.
It’s what you know for sure that just ain’t so”
A good financial model is built on top of an assumptions table – a list of all your guesses.
These might be things like:
Prices per unit
Sales per day
Your own salary
Utilities per month
Shipping costs, etc
By listing your guesses in a clear table, you reduce the chances of making a mistake.
The table ensures that when you change one number (e.g. price) the whole model immediately updates, and you can see the impact of that change.
It also allows other people to come in and ask good questions.
I’ve had this with my models – people with expertise can see my assumptions and then suggest better figures.
This helps you make better guesses and projections, so you’ll make better decisions that strengthen the business.
What’s In It For Me?
There are four main benefits for your enterprise:
1. Peace of mind
Financials sound much scarier than they actually are.
By learning the terminology and core concepts, you’ll start to enjoy the process instead of fearing it.
2. Fewer cashflow issues
By seeing how money moves in and out of your company, you’ll start to remove the bottlenecks that drain your spare cash.
3. Check the impact of changes to your business
Like crash tests, you can see the impact of future modifications without risking your safety.
4. Find flaws sooner rather than later
Like a Dexa scan, the truth may not be flattering, but it gives you a good starting point to build on.
If there’s a problem with your model, would you rather find out now, or once you’ve hired people and ordered tonnes of inventory?
Next let’s look at the skeleton of your model…