The Importance of a Financial Model for Forecasting
Many companies develop an annual budget based on their Profit and Loss Statement for the coming year. While this provides a good picture of expected revenue and expenses, it does not adequately reflect the pace of cash flowing through the business. Business management requires a full financial model in order to predict the pace of cash which allows decisions to be made such as capital expenditures or debt repayment.
What is a Financial Model?
A financial model is a tool used by management and business owners to predict and assess a company’s future financial condition based on a set of assumptions. A model operates by taking a company’s historical financial trends (income statement, balance sheet and cash flow), and assessing patterns in certain aspects of the business and then using those trends to predict what the financial results will be based on those assumptions. For example, when revenues increases, how might this affect a company’s accounts receivable, inventory, or cash levels?
Financial trends tend to vary by business and industry. However, these patterns can be applied to a forecast based on a set of assumptions provided by the company’s owner or management. It is important to acknowledge the fact that these assumptions can be changed or manipulated at any time, as compared to a budget which remains static. This is what makes a financial model so useful and important to the management decision making process.
What is the Purpose of a Financial Model?
Generally speaking, a company’s financial model serves the following uses:
- It will help determine realistic market potential for a new product, service or business.
- It will help quantify the amount of investment required to get the company to grow to the next level or to get a new company off the ground.It will help show owner/investors a timeline and path to positive cash flow and profitability.
- It will help facilitate a valuation of a business in a transaction.
Particularly for early-stage and young companies, financial models help visualize and quantify how viable a business might be for investors or a lender. As an investor, it is critical to know exactly how your money will be spent and when you can expect a return on your investment. Business owners should also understand these implications for their investment. Too many times capital or debt will be acquired, particularly from credit cards or friends/family, without doing this analysis. With a financial model, the amortization of debt can be modeled out over time and the effects of repayment seen on cash flow. This is extremely useful for lenders such as banks and or family/friends who want to see how much risk their money will face in a company.
Contact the Giersch Group for help creating a financial model for your business to help you forecast future profits and cash flow.