When the ground starts to shake around Cape Canaveral, it is a matter of seconds before a rocket is launched and begins its journey into space. But leading up to this moment there have been months, if not years, of preparation and planning for every eventuality. Countless inputs are considered and risks mitigated by modelling various potential scenarios. Without these meticulous processes, a mission is destined for failure.
Like launching a rocket into space, a business needs a thought-out and refined plan to have any hope of lifting off. A key step in assessing the viability of a business plan is forecasting what could be achieved, taking into account as many factors as possible. Such factors include expected sales, customer types, product and service pricing, human resources, capital expenditure, and financing requirements.
How do we consider this plethora of factors effectively, you may ask? Enter the Financial Model. A Financial Model, as the name suggests, seeks to model the potential performance of a business by combining relevant inputs and assumptions into a financial forecast. A Financial Model can be used as a budgeting tool, to stress-test different scenarios, to calculate the financial impact of a new project, to allocate corporate resources, and to determine the value of a company.
The first step in developing an effective Financial Model is to apprehend the environment in which a business operates and to identify inputs that will impact its performance. At Creative CFO, we have prepared Financial Models for companies like Wingu Academy, BancX, and Automata; all three of which are exciting, high-growth companies, but operate in significantly different business environments.
For Wingu Academy , the inputs we considered include student enrolment numbers, subjects and classes per student, books per student, and the number of classes a teacher can manage. For BancX , we factored in banking certification costs, volumes of accounts and cards, interchange fees, interest rates, and platform fees. For Automata we needed to consider the manufacturing process for robots, including production capacity, supplier terms, shipping policies, customer warranties, and commission structures for their sales team. Because no two businesses are the same, the specific inputs to every Financial Model are unique.
Once the inputs for the Financial Model are determined, the second step is to consider how these inputs may change over time or how they may be influenced by different scenarios. Again, the way this step plays out is dependent on the specific business. For Wingu Academy , the scenarios we considered hinged on the number of enrolled students, for BancX the scenarios were driven by the number and type of customers that were onboarded, and for Automata the scenarios were driven by considering business performance for different levels of demand and stress-testing whether production could keep up with each scenario.
We develop a “low road”, or worst-case, scenario based on the premise that things don’t quite go according to plan (e.g. low student intake, low volume of accounts, or inefficient manufacturing processes). This gives the business owner an indication of the risk involved in embarking on the business journey. On the other end of the scale, we build out a “high road” scenario that portrays to business owners and investors the results that the company has the potential to achieve. Somewhere between these two extremes is the “middle road” scenario where we use more conservative estimates and assumptions for each of the required inputs. An effective Financial Model allows the user to toggle between every scenario with the click of a button.
Finally, we need to arrange the inputs into a format that allows business owners and investors to easily observe and evaluate the financial performance of a company over time. The format is known as the 3-Statement Model. It is a combination of an Income Statement, Balance Sheet, and Statement of Cash Flows. These three statements are presented on one page, allowing the user of the model to observe how income and expenses generate assets and liabilities and translate into cash for the business. The final line of the 3-Statement Model is typically Free Cash Flow to Equity (“FCFE”) – this figure is the cash that can be distributed to the shareholders of the company as dividends after all expenses, reinvestments, and debt repayments are taken care of. FCFE can also be altered into Free Cash Flow to the Firm (“FCFF”) by adjusting for debt. FCFF represents the cash flows available to both shareholders and lenders. Both of these figures are vital metrics that investors use to arrive at a Business Valuation.
A Financial Model is an essential step in making sure your business doesn’t get stuck on the launch pad. Get in touch with our investment team to ensure your business is ready for lift-off.
