What Is Financial Modelling (And Why Every Business Owner Should Be Using It)
Financial modelling is a powerful tool that allows business owners, especially those running small to medium-sized enterprises (SMEs), to make informed decisions based on data-driven forecasts. It’s essentially building a mathematical representation of a company's financial performance, which can be used to predict future outcomes under various scenarios. For SMES, this insight is invaluable for strategic planning, securing funding, and navigating economic uncertainties.
What is Cash Flow Forecasting and Financial Modelling?
Financial modelling is the process of creating a representation of a company's financial performance in the past, present, and future. These models are typically built using spreadsheet software like Microsoft Power BI, Microsoft Excel or Google Sheets and involve forecasting a company's income statement, balance sheet, and cash flow statement. While large corporations use financial models for complex tasks like mergers and acquisitions, portfolio management, and financial modelling, their relevance to SMES is often underestimated. For SMEs, financial modelling provides a simplified yet effective way to understand the financial implications of various business decisions. At Tullastone, we tailor these models to be practical and directly applicable to the challenges and opportunities faced by Australian SMES.
A Brief Overview of Financial Modelling
Financial modelling allows business owners to test different scenarios and understand their potential impact on the business. This is particularly important for SMEs, which often operate with limited resources and face greater vulnerability to market fluctuations. For example, a financial model can help an SME owner determine the impact of a price increase on profitability or assess the feasibility of expanding into a new market. Moreover, a well-constructed financial model is often essential for securing funding from banks or investors. It demonstrates that the business owner clearly understands the company's financials and plans for future growth. Tullastone assists SMEs in developing robust financial models that can withstand scrutiny from potential lenders and investors.
Why is Financial Modelling Important for Business Owners?
Financial modelling plays a crucial role in forecasting and strategic planning for SMEs. It enables business owners to:
Forecast future revenue and expenses: A financial model can provide a realistic projection of future financial performance by analysing historical data and making assumptions about future market conditions.
Assess the impact of different business decisions: Financial models allow business owners to simulate the impact of various decisions, such as launching a new product, hiring additional staff, or investing in new equipment.
Identify potential risks and opportunities: By analysing the model's outputs, business owners can identify potential risks and opportunities that might not be apparent otherwise.
Develop a strategic plan: A financial model can serve as the foundation for a strategic plan, providing a clear roadmap for achieving the company's financial goals.
For example, a cafe owner in Sydney might use a financial model to forecast revenue based on anticipated foot traffic during peak tourist seasons, accounting for variable costs like coffee beans and staffing. This allows them to strategically plan inventory and staffing levels, maximising profitability during busy periods. Tullastone helps SMEs like this cafe develop practical, insightful models.
What Factors Influence Financial Modelling?
Several key variables affect the accuracy and reliability of a financial model. These include the quality of the data used, the assumptions made, and the influence of external factors such as economic trends.
The Economic Environment
Economic indicators such as GDP growth, interest rates, and inflation can significantly impact financial modelling for SMEs. For example, a period of high inflation can increase the cost of goods and services, affecting a company's profitability. Conversely, strong economic growth can increase demand for a company's products or services. Consider an Australian construction company: rising interest rates can dampen demand for new housing, directly impacting projected revenue. Tullastone helps SMEs interpret these economic indicators and incorporate them into their financial models, providing a more realistic and nuanced view of the future.
Industry Trends and Benchmarks
Understanding industry trends and benchmarks is critical for creating realistic and relevant financial models. This involves analysing industry-specific data, such as average revenue growth rates, profit margins, and operating expenses. By comparing a company's performance to industry benchmarks, business owners can identify areas where they are performing well and where they need to improve. For instance, a retail business in Melbourne should benchmark its sales per square metre against similar businesses in the area to ensure its performance aligns with industry standards.
Historical Financial Performance
Analysing historical financial performance over the past 3-5 years is essential for establishing a baseline for future projections. Key financial metrics to consider include:
Revenue growth: The rate at which revenue has increased over time.
Profit margins: The percentage of revenue that remains after deducting the cost of goods sold and operating expenses.
Cash flow: The amount of cash generated by the business.
Debt levels: The amount of debt the company has outstanding.
Tullastone’s analyses often involve identifying trends and patterns in these metrics to inform the assumptions used in the financial model. For example, if a business has consistently experienced strong revenue growth over the past three years, it may be reasonable to assume that this trend will continue in the future. However, it's also important to consider any factors that could affect future performance, such as changes in the competitive landscape or economic conditions.
What’s Included in a Financial Model?
A comprehensive financial model typically includes several core components, each providing a different perspective on the company's financial performance. These components are particularly relevant for SMEs navigating various business scenarios.
Core Components of Financial Modelling
The core components typically found in a financial model are:
Assumptions: These are the underlying assumptions that drive the model's projections. Examples include revenue growth rates, cost of goods sold percentages, and operating expense assumptions.
Income Statement: This statement projects the company's revenue, expenses, and profit over a specific period.
Balance Sheet: This statement projects the company's assets, liabilities, and equity at a specific point in time.
Cash Flow Statement: This statement projects the company's cash inflows and outflows over a specific period.
Scenario Analysis: This involves testing the model under different scenarios, such as a best-case, worst-case, and most-likely case.
Tullastone uses these components to build detailed financial models that enable SMEs to make informed decisions. For example, when assessing the viability of a new product launch, Tullastone would develop a model that projects the incremental revenue, expenses, and cash flow associated with the product, considering various market scenarios.
Key Assumptions and Inputs
Key assumptions and inputs are the building blocks of any financial model. These can range from macroeconomic factors like inflation rates and interest rates to company-specific data like sales growth and cost structures. Sensitivity analysis should be performed on key assumptions to understand how changes in these inputs impact the model's outputs. For example, a model for a farm might heavily rely on rainfall projections and commodity prices. A slight change in either can significantly alter profitability.
Outputs and Financial Statements
The key outputs of a financial model are the projected financial statements: income statement, balance sheet, and cash flow statement. These statements can be used to assess the company's profitability, solvency, and liquidity. In addition, the model can generate various financial ratios and metrics, such as return on equity, debt-to-equity ratio, and current ratio. These outputs are critical for SMEs because they provide a clear picture of the company's financial health and can be used to support decision-making in various scenarios, such as securing a loan, attracting investors, or negotiating with suppliers. Tullastone ensures these outputs are tailored for clarity and actionable insights for business owners.
How to Create a Financial Model?
Creating a financial model can seem daunting, but by following a structured approach, business owners can develop a useful financial planning and decision-making tool.
Defining Objectives for Your Model
The first step in creating a financial model is to define its objectives. What specific financial questions are you trying to answer? Are you trying to forecast future revenue, assess the feasibility of a new project, or determine the impact of a potential acquisition? Aligning the model with short-term and long-term business goals is crucial. For example, a growing tech start-up might want to project cash flow needs over the next 12 months to secure funding. The model should then be specifically designed to answer this question.
Selecting the Right Tools
The choice of tools will largely depend on the complexity of the model and the user's familiarity with different software packages. While spreadsheet software like Excel and Google Sheets are the most common choices, specialised financial modelling software may be more appropriate for complex models. Excel remains a strong option for many SMEs given its accessibility and familiarity. Tullastone frequently utilises Excel, providing clients with models they can readily understand and update.
Building the Structure of the Model
Building the structure of the model involves outlining its key components, such as the assumptions, income statement, balance sheet, and cash flow statement. It's important to tailor these components to the SME's unique circumstances. This might include customising revenue drivers based on the business model, incorporating industry-specific metrics, and accounting for any unique financing arrangements. At Tullastone, we work closely with SMEs to understand their specific needs and build relevant and insightful models. For example, the model will focus on metrics like customer acquisition cost, churn rate, and lifetime value for a subscription-based business, rather than traditional retail sales figures.
Should You Invest in Financial Modelling?
Financial modelling offers significant benefits for SMEs, enabling them to make informed decisions, secure funding, and navigate economic uncertainties. By providing a clear understanding of the company's financial performance and a roadmap for future growth, financial modelling can empower business owners to achieve their strategic goals. If you're an SME owner in Australia looking to gain greater control over your finances and make more informed decisions, consider investing in financial modelling. Contact Tullastone today to learn how our tailored financial modelling services can help your business thrive.