For any major business decision, a financial model is prepared which takes into account the finance, acquisition, and target of the project. These useful tools enable a business to take calculated risks in a cost effective manner, against a wide range of assumptions, identify optimal solutions by analyzing financial returns and understand the impact of resource constraints.
It is the duty of the financial department to figure out a balance or at least an acceptable level of imbalance between the different cash flows that it manages. It is this uncertainty of finding an imbalance, which makes financial models an integral part of any business. Besides the risk analysis, financial models also understand opportunities that maybe inherent in that business ecosystem.
Some entrepreneurs think that developing financial models is waste of time, considering it to be just a bunch of inputs variables. However, if the input variable is mistaken then the whole financial model stands to fail. What has to be understood is that the results are not the only parts of a financial model. Nobody cares about hockey stick growth of a business, but how the growth has been achieved. Besides the results, the thought process matters the most. A detailed financial model is not the important thing, it is all about keeping a hold on the major factors that are in the models and then getting data to help predict these variables. To generate the needed data, entrepreneurs can take the help of data and create scenarios, which are advantageous to the business.
The following are some of the benefits of developing a financial model:
Analytical lens: A financial analysis and modelling approach would provide entrepreneurs with the much needed analytical lens to a startup. Not only would the model allow entrepreneurs to think about the business with new founded objectivity, but also force entrepreneurs to construct numbers around these assumptions. These numbers would be conducive for the success of the business, as the financial model would capture all drivers of the business in a single and cohesive model.
Operating model: During the development of financial model, what is expected of the business is laid out in a chronological manner, in a very granular manner. It is a sort of roadmap for the business.Through financial modelling, milestones can be set, progress tracked and, issues identified and resolved.
Risk assessment: Financial models would highlight all key risk points for the startup. This is important especially for them because expenses precede revenues, but balancing cash flow helps monitor burn rate and also figure out when the company can break even.
Market exploration: These financial models allow businesses to have multiple market scenarios analyzed. The permutation and combination of various factors enables the businesses to figure out the key factors that would best work for the business.
Pitch and sales tool: The financial model can become the backbone for various sales and investments pitch enabling the business to pitch according to their needs.
Most entrepreneurs lack the basic knowledge of financial modelling and therefore, have no idea of where to start. They struggle is to create the models themselves, as there is no template or set best practices that can be followed. To make the best financial model suited to the requirements of the business, the best route is to look at other samples, conduct the basic due diligence and keep building, customizing and editing the model till success is achieved.
Besides these complications, entrepreneurs also have difficulty in understanding how much of the financial model should be built. The key, as per market experts, is to build a viable financial model that will help in taking key decisions and communicate the story behind the business. This simple viable model can either be a cost budget or a robust projectionof new products of the business.
The model should also reflect various kinds of dependencies that occur between consecutive periods of time and between activities. The models can also include dynamic control mechanisms which would explain these dependencies over time. In the detailed financial models, description of the correlation between different asset types is given, for example, correlation between different types of business are sometimes included for a better understanding of the business ecosystem. These models are further developed as and when the need arises.
Therefore, we can safely say that financial models facilitate an accurate evaluation of all critical complex business decisions. It is a comprehensive and an independent financial review which is conducive to the business and the market that the business survives in.