5 Questions for Choosing the Most Effective Financial Modeling
Financial models are powerful decision-making tools. They range from simple to complex and are used throughout the business by c-level executives, general managers, strategic planning teams, financial analysts, and quality directors. Potential investors also use them to evaluate the risk and scalability of a company.
The financial model that a company chooses validates the business model and must be consistent with its business plan. It is the basis for fund-raising, and it is an effective and consistent way to communicate to investors, board members, and employees as the company gains traction and grows.
Using Assumptions and Data
Financial models are built with historical and real-time data that reflects past and current performance and with assumptions and forecasts about the future. Modeling the future involves many levels of assumptions—start with “the future will arrive.” There are assumptions about timelines, market segments, economic conditions, product timelines, customer acceptance—the list goes on and on.
Key assumptions clarify and quantify key business risks, which markets to prioritize, and critical success factors. By linking business milestones to critical assumptions, management can determine which metrics are most vital in managing the business.
Deciding Which Financial Model to Use: Purpose and Types of Financial Models
Financial models are built on the three financial statements of accounting: Income statement, balance sheet, and cash flow statement. These cornerstone statements are the most important and powerful financial tools a company has to build and grow a sustainable company. They are the first sources of information investors use to evaluate a company as a potential investment.
Based on a company’s business strategy and capital decisions, or an investor’s investment objectives, additional financial models can be used as tools to analyze and evaluate specific choices. Ultimately the consideration of which financial model to use depends on the answers to the following questions.
- What is the financial condition of this company?
Financial Statement Model – The Income Statement, Balance Sheet, and Cash Flow Statement (CFS) are written records representing the company’s overall financial performance and business activities. The balance sheets list assets, liabilities, and stockholders’ equity at a point in time. The income statement, also referred to as the profit & loss (P&L) statement, represents a firm’s revenues and expenses in an accounting period and, subtracting expense from revenue, produces net income, the company’s profit figure. The cash flow statement represents the sources and uses of cash, showing how the company generates money to pay for its current and long-term debt obligations.
These statements are subject to audit by government agencies and accounting firms for taxing, investing, or financing purposes. They are the cornerstone of analyzing daily operations and due diligence and reporting to the board of directors.
- How should we pay for this acquisition?
Leveraged Buyout Model (LBO) – LBO is the acquisition of another company with borrowed money. The assets of the purchased company and the acquiring company’s assets are often used as collateral for the loans. LBOs are used to take a public company private, spin-off part of a company as a separate business, or change business ownership.
- Should we invest in this project?
Discounted Cash Flow Model (DCF) – DCF determines the value of an investment based on future cash flow and the time value of money. DCF relies on assumptions and estimates of future cash flows and discount rates. DCF is a useful tool to use when deciding between two or more options.
- How profitable is a specific segment of the business?
Unit Profitability Analysis – At the simplest level, this calculates revenue minus expenses to determine the profitability for a given business unit. The approach can be applied to a division of the company, a specific product line, or an individual item.
- Should we invest in this company?
Using Rev1 as an example, we analyze five years of a company’s financial statements to evaluate whether the founding team knows how to scale and grow a business. We study the sources and uses of funds to assess how the management teams have deployed cash so far and how they plan to deploy future investments to achieve the critical commercial milestones. We apply unit profitability analysis—often down to the individual customer level—to determine whether the business model represents a scalable, high growth opportunity.
Tips for Effective Financial Modeling
- Be consistent with the business plan and answer essential questions for internal and external audiences. For example, when will the company begin generating positive cash flow consistently. Or will additional financing be required?
- Clearly state the model’s fundamental assumptions and the conclusions drawn from the model. For example, key strategic hires will join the team by June. Or that the company will reach 5 percent of the serviceable obtainable market in three years.
- Effective financial models are complex enough to produce the analysis to support sound decision-making, yet straightforward and simple enough for the desired audience to understand.
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