Why build a financial model?

As a director or senior management of your company how do you:

  • Determine and monitor the value of your business?

  • Assess the value of opportunities presented to you?

  • Monitor future cashflow requirements?

  • Ensure an efficient capital structure?

  • Manage your debt provider and their covenants?

A financial model is the solution for these questions

Financial models are an essential tool every business should have in its day-to-day toolkit. Commonly a financial model is only prepared when a company is looking to undertake a major transaction, such as raising capital, an acquisition or selling the business. Instead every business should maintain an operational financial model that informs management and forms the centre of decision making.

A well constructed financial model will:

  • empower key decision makers to forecast the future performance of their business

  • assess potential decisions on cashflow and shareholder value

  • support operational decision making and present the business with the bigger picture

  • allows the business to stress-test their growth assumptions and identify key potential risks

  • provide management with the ability to quickly assess the value to the business of opportunities that present themselves

  • support pricing discussions between shareholders and potential shareholders

  • support discussions with banks around covenants and future funding requirements

What characteristics makes a good financial model?

A well constructed financial model is more than just a spreadsheet. A good financial model should meet a few key characteristics:

  • Driver Based. Forecasts are constructed based on the key operational drivers of the business rather than generic % growth factors. For example, for an inventory based business this could mean revenue calculated based on # of units X $ per unit with COGS also forecast on $ per unit basis (rather than a straight %). This will empower users to stress test different growth assumptions, sale and cost pricing.

  • Logical flow. This means the model has clear input and output, consistent formatting and formulas. Often colour coding is used to make information easier to identify and highlight any key information to the user. Users should be able to find the information they need for decision making and make adjustments to key assumptions without requiring an instruction manual.

  • Transparency. A model should distil complicated requirements into simple calculations. The more complicated a model looks, the lower a user’s confidence in the model will be due to the risk of potential errors in the calculations.

  • Three-Way model. The model should generate a Profit & Loss, Balance Sheet and Cashflow statement so the end user can see the effect of changes to assumptions on all aspects of the business.

  • Error Checking. Built-in error checks should be used so the user will see instantly (and not after a day’s work) if a change generates an error in the model.

  • Sensitivity Analysis. Sensitivity and/or scenario analysis are a key feature of models. A scenario analysis will allow a user to stress test their base case assumptions.

Why should your company maintain a financial model on regular basis?

Often we see companies where a financial model is constructed and discussed and then left on the shelf until the end of year. Once the year end financial results are prepared often the there is an off-hand comment that they didn’t match forecasts and the loop starts again.

Financial modelling should not be a closed-loop set-and-forget process. At Chessboard we recommend updating an operational financial model on at least a quarterly basis so it can be at the core of the decision making process. This enables the model forecasts to be regularly updated as new information becomes available, and for the key driver or reason of any discrepancies to be analysed (rather than a simple “revenue was out”).

On a regular basis, firms should update their financial models with:

  • An update of actual data for the months completed;

  • A comparison of actuals against the forecast; and

  • A review of forecast assumptions to analyse whether any reforecast is required.

This process will enable strategic and operational decisions to be based on the latest financial data and empower the best decisions to be made and the effect of those decisions on firm’s value understood.

A well designed and constructed financial model will help board and management grow with the business and plan and execute their strategies for years to come.

Cheyne Buckley