Few analysts understand that financial modeling nothing but workings on excel spread sheet. Partially true!
Financial modeling is of building a model which represents real world financial situation. This is a mathematical model. It is designed to represent the expected performance of a business or project or business portfolio.
Myth and truth attached with financial modeling
It is only for accounting purposes:-
There are many accounting software available globally. This software is just used to see the result. But financial modeling is developed for many purposes such as corporate finance, asset valuation, project management etc.
It is a standard product:-
Many analysts believe that financial modeling is a standard product and can be used the same model everywhere. But this is not true. Even in the same organization, different financial modeling shall be used for different purposes such as valuation, corporate finance, estimating risk return attached with portfolio etc.
It is very easy to develop:–
Since the model is a representation of real world situation, anything expected to happen in the real world has to be incorporated in the model to know the impact on the profitability and wealth. Therefore assessment and forecasting of data input are very critical. Moreover, all the variable inputs should be considered and level of impact needs to be assessed with proximity.
Small business does not need financial modeling:–
financial modeling can be used even for small businesses including start-ups. For start-ups, it is helpful to build out a model to understand all the variables needed for success. The act of building out the model will bring different expenses, revenue ideas, and cash flow requirements to the surface.
The Same model can be used every time:-
NO. as the time passes, business becomes bigger i.e. the internal variables are going to change. Also, external market dynamics will also shift. Therefore, there is need to update the mathematical model.
How to develop a financial model for your business?
Step 1:- Understand the business:-
Clarity on business’s aspects is very important. It is imperative to know the product’s worth, industry aspects, change in dynamics of the industry, funds as and when required and impact of any kind of change on business.
Step 2:- Identify the variables:-
It is not possible to identify all the variables at a time. But the list of the variables as many as possible is required. Also, it is the best idea to find out the most critical variable. For start-ups, it is bit difficult but business understanding can help in that.
Step 3:-Assessment of the impact of those variables:-
After identifying the variables, the impact of those variables should be assessed. The impact may be upside or downside.
Step 4:- Give quantitative figure to those impact:-
This is one of the most difficult tasks to convert qualitative aspects to convert into the quantitative figure. But it is required because financial modeling is a mathematical model. For already running businesses, it is a bit easier because the previous impact is known but for startups it is difficult. The way out is to keep tentative figures and as soon as any change in the variable is noticed quantitative figures should be incorporated.
Uses of financial modeling:
The most popular use of this mathematical model is for internal analysis for decision making. Be it market environment or internal situation, these are not static.
The financial model can be presented to the investors/fund providers to provide them to have a fair view so that they can have the good confidence to invest in the business.
To conclude, business owners should appreciate the value derived from the financial model. It will help in the growth of the business and will keep minimum risk with maximum return. Let us not considered developing a model waste of time and use it properly. A start-up should even be more proactive in developing it to grow faster.