September 16th, 2011 | 
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I am always amazed at how many entrepreneurs run their business without a thorough understanding of their business finances. And even for large companies, in many cases find that large projects or start new business units are started in the absence of a solid business case to bring the expected benefits of the future together with all costs making related to new venture happen. People tend to have great ideas and believe in them. Support these ideas with a financial model that breaks down the relevant aspects in concrete figures can prevent from losing too much money. Knowledge gained from a good financial model is great. I find that it is good practice to have the model in place for any large enterprise. Moreover, I find that companies that made the model in a later stage, they realized that they could have avoided many mistakes by crunching the numbers earlier.
Here’s 10 reasons why establishing a good financial model is as important for many types of business activities:
1. You will not know what you know. When making a financial model more likely to understand that business success depends on some very important assumptions. In many cases, these key assumptions are even more difficult to predict, because they often have to do with the proceeds of which strongly depends on customer responses to your new offering. Once you understand the parameters critical to your financial model, you can try to find data based on relevant assumptions, such as through data mining or market research
2. You can run the risk scenarios. As mentioned earlier, people believe in their ideas. Therefore, you will see a trend that the numbers are exaggerated. Remember doc-com boom with revenue estimates and inflated its crash below. A good financial model let’s easy to run scenarios. What if the product launch is delayed by 3 months? What happens if only half as many customers than expected actually buy? What happens if oil prices rise by 50%? What if a competitor comes before us? What if a seller falls off and you lose time to replace the vendor? What if your second round of fundraising is not successful? And so on
3. You will know what to focus on. By running the sensitivity, you will learn what really matters in your business. A control is the cost of operations? A collection is quick money from your customers? Is the rapid expansion in the market, so a land grab? Once you know this, you will clear what to focus on. You can connect all the teams, incentives, processes, etc. with the business aspects that make a difference
4. You will understand the risks of cash-flow. Important for any business but crucial for startups and small businesses. If you do not manage your cash flow, you will run the risk of going bankrupt. Therefore, you should build your financial model in a way that it reflects real cash-flows. This is different from standard profit and loss statement. Accountants will tell you that investments can be depreciated over many months, but mostly you will have the effect of money in the first month. Also, mainly Accountants recognize revenue when you offer your product or service. However, the respective cash-flow will occur once the customer pays the bill which could be 30-60 days later or even more
5. You will be able to better structure the incentive models. There is a tendency to payment based on the success of employees, contractors, vendors and suppliers. A typical example is to offer product development companies a share of the proceeds from the sale of the product concerned. Financial model will help to come up with reasonable figures. Retailers, for example, will require “and it can get if we are three months later on the market?”. Financial model will give you the answer
6. You can see if the option is available. Many businesses end up being a lot lower in relative profit. I know people that started several years ago the business and find themselves earning much less than as employees of a large company, but are far busier than before. Now, they consider a return to corporate life. These types of unexpected might happen less if the numbers would have been understood before starting the initiative
7. You will understand how to structure the organization. Especially in businesses that require many people to act, the financial model will give you an idea of what you will need to rise in expected earnings figures. It is easy to visualize a large increase in income, but many businesses these numbers will require a large and complex organization. For some businesses this also becomes a limiting factor such that the profit expectations can not be met at all. In these cases, the company needed to review the overall business model or structure of different business model to be scalable or not pursue the case. Financial model helps to identify such restrictions and come up with solution options
8. You know when you need external financing. Financial model will give you a better idea of what type of financing you need for your business. After running some scenarios you will know how much money you need and when
9. You can use the model for budgeting and performance management. It is clear that the model itself is already a form of high-level budget. You can easily break down the numbers into the model to individual budgets. On top of that, because it has helped identify key value and risk drivers, which can easily be derived KPI’s for your players and manage performance against these drivers
10. You can use it to connect all stakeholders. concrete numbers may help to get all the actors engaged for the same purpose. Provide all, especially investors or board members, understand and model the fundamental value and risk drivers. How will you reduce this risk being confused with site issues and get all stakeholders moving in the same direction
As you can see, there are many aspects, which helps a financial model. In my opinion it is crucial to making things work. It does not take much to develop, but makes the decision-making so much easier.
When you develop such a model type, be careful that you do not make it very detailed. Are there any printer model you have to buy. To facilitate, work with reports, eg % wage benefits, costs for office space and equipment for employees, costs for delivery order, etc. If the model is quite simple, you can connect things together more easily be able to run scripts.
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