The Importance of Having a Financial Model
The success of your family business is directly related to how informed you are about your company’s financial performance. Having a solid internal system, a financial model, in place for summarizing expenses and earnings allows a business to determine the impact of future events and business decisions. While it’s often a level of detail many family businesses avoid, there is tremendous value in the ability to plan your cashflow and forecast how various scenarios will affect your business.
If you don’t have the right financial information to make a business decision – you will make a bad one.
We make decisions in our businesses every day, and each of them impact the business financially in some way. Are your business departments all making the money they should be? Are you in a position to expand, update your equipment, or purchase a building? What area has your strongest return on investment (ROI)? Do you have an area that is dragging your business down? Will you end the year strong enough to pay out bonuses? Having a financial model allows you to answer all these questions, and is the only way to grow your business. You’ve got to know your numbers!
What You Don’t Know Can Hurt You
Having accurate financial reports are important because they contain significant information about a company’s financial health, and you can’t plan for your future without them. Many businesses are resistant to go to this next level of financial modeling because they’re afraid of what they might learn. What we don’t know, can’t hurt us, right? WRONG! If you don’t know your financials then you really aren’t going anywhere. While we can’t promise you won’t learn some information that you don’t like, once you have these financial tools, you can take the necessary steps to change what you don’t like. You can build the areas of your business that you always dreamed of, instead of focusing on just getting by.
What is a financial model used for?
Business owners and leadership use financial models to make informed decisions about:
- Financial analysis to determine profitability, ROI, loss areas
- Raising debt or equity capital
- Making business or asset acquisitions
- Growing the business (opening new locations, entering new markets, etc.)
- Selling or divesting assets and business units
- Forecasting and predicting the years ahead
- Prioritizing capital allocation
The Basic Components of a Financial Model
Financial modeling moves beyond day-to-day bookkeeping, and provides numbers on all aspects of a company’s operations. They are invaluable decision-making tools, used to analyze current areas of business, estimate the cost and return on new projects, anticipate the impact of a major economic or market change, or to determine ownership stock payouts or bonuses. With a financial model, a business can estimate its value, and the value (or loss) of business units within the company. You can forecast for your business’s future, test various scenarios, mitigate risk, set more accurate budgets for projects, and allocate your business resources.
These financial tools are important for any size business because, of course, all businesses want to be successful.
Let’s take a look at the various elements of a Financial Model:
Return on investment is the ratio between net profit over a period of time and the cost of the investment. ROI is a key performance indicator that is used to determine profitability of an investment or area of business, and it allows you to compare that return to other business investments. Knowing which areas of the company provide the best (and worst) ROI help inform critical business decisions.
If I invest this today, what is the return on this investment? When do I get the return and what is the impact to our core business?
Profitability & Cost Analysis
Cost analysis is the act of breaking down a cost summary into particular areas of the company, and determining the true costs of specific business efforts. It also allows for accurate comparison of costs to one another, and to industry averages. This analysis enables a business to analyze their pricing, profit/loss centers, and determine how a new expense may impact overall costs to the company.
How do we price our products/services accurately? Do we have business areas that don’t make any money? Do we have business areas drawing down the rest of the company? What are our true costs of doing business?
Capacity planning is the process of determining the impact of an investment or changing demands for products on the business’s ability to maintain operations. It helps businesses determine budgets and any scaling necessary to meet a demand. It helps determine how services are offered, products are manufactured, and the necessary time-frames and staff required to meet current demand and cover all operational costs.
If we add this new business unit, do we have enough current staffing for it? How many new people, extra space, or additional equipment is needed?
A financial forecast is an estimate of future financial outcomes for a company based on specific assumptions. Forecasts are used to develop projections for profit and loss statements, balance sheets, and other cash flow estimates. Many family businesses do a great job at keeping up with their day-to-day actuals, but they aren’t really planning for the future. To make important financial decisions going forward, and maximize profitability, you have to forecast.
How much money are we going to make next year? Are we making or losing money? How much are we going to spend next year? What will our family distributions be? Are the financial and business assumptions still valid?
Budgeting & Cash Flow Analysis
Budgeting is simply an estimation of revenue and expenses, over a period of time. Having this spending plan allows a business to determine in advance whether it will have enough money to do the things it needs to do, or would like to do. A cash flow analysis goes hand in hand with budgeting showing a business’s liquidity. A cash flow analysis estimates how much cash you have available at a given time.
Can we afford to expand our business next year? Do we have the money to purchase the new equipment we need? How much cash do we have on hand?
A Financial Model allows business leadership to answer critical questions about the financial health and future of the business.
What would a Financial Model look like for my business?
A useful financial model is customized for every business. Ultimately, however, the model must build an income statement, a balance sheet, and a cash flow analysis. It tracks your actuals, and gives you mechanisms to plan effectively for the future. The business budget, financial forecast, and cashflow plan all come out of the model. As we’ve said, all business decisions impact and are assisted by the financial model.
You can use a model is so many different ways as you consider different business decisions. You can plug in different sales and expense numbers to see how it impacts the business overall. Because it allows you to track financials and financial performance over time, you can make financial forecasts and set budgets. It also lets you do a lot of financial metrics – how fast am I collecting A/R, how quickly am I paying my bills, how solvent is my business and how do my actual results compare to budget just to name a few, A financial model is the next step to being able to answer financial questions strategically and truly take charge of your business goals.
One of the greatest benefits of these tools is the ability to run “what-if” scenarios. At Quad Group, we love scenario planning because you can plug in different situations and consequences, and see how they will impact your business. They are powerful tools because you can figure out what you need to do now in anticipation of different scenarios.
If the pandemic continues, what impact will it have on our business? What if our business drops 25%? What is the worst case scenario? What is the best case scenario? What if we invest in this business – do we have enough cash to do it, do we need to borrow money, do we need to pull from our reserves?
Unfortunately, without a financial model that uses the tools described above to maintain a handle on your financials currently and in the future, you don’t have the information to run scenarios accurately.
Having a Financial Model allows a business to track performance over time, and be able to answer strategic financial questions.
Creating the Financial Model
The financial strategy of any business must fully align with the overall business strategy. When we are working with a client, we begin by discussing your business goals for growth and development. When we know what the strategy of the company is moving forward, we are ready to begin to build your financial model to reach those goals.
At Quad Group, we work with clients to set up a financial model that fits their unique business, and teach them how to look at financial information and determine the impact on the business currently and in the future.
Our work includes:
- Preparing an income statement
- Evaluating the balance sheet
- Ensuring strong cash flow
- Preparing budgets
- Developing full forecasting capabilities
- Assisting with financial model implementation when needed
Are you ready for the next level?!
We believe we are very different at Quad Group because we come from such diverse family businesses, and have multi-disciplined experience within our own family businesses. Having worked with so many family businesses over the years, we deeply understand their complexities. Financial models aren’t built in a vacuum, it needs to tie into your overall business goals, and we have that big picture view.