Benefits of Financial Modeling
Financial Modeling is critical to any startup or to an existing business seeking to capitalize on the next level. When the term “Financial Modeling” resonates, most companies think of a three to five year financial analysis that is attached to a Business Plan. While this definition is accurate, financial modeling applications are more extensive and necessary to provide vision, to garner early stage investors, and to provide stakeholders with valuable information (i.e., a VC Firm requiring data to manage their investment).
Why Utilize a Financial Model?
So, why should a business consider these financial modeling applications? The answer can vary depending on the needs of the organization, but can encompass:
- Managing cash flows
- Identifying financial risk and strategy
- Analyzing quality of earnings
- Examining EBITDA
Like most companies, human capital is stretched. So, whether the individual is a CEO, sales, marketing, or purchasing executive, financial modeling is a focal point in making decisions.
In addition, external stakeholders, such as bankers, investors, venture capital/private equity firms, and vendors demand financials, as evidence to properly fund an organization’s growth.
Two Practical Examples of Financial Model Benefits
Consider a Venture Capital or Private Equity Firm
Venture Capital and Private Equity firms are focused on the financial health of their operating companies. Their main question – What is the return on their investment? To answer this question, they require a rigorous budgeting process that encompasses financial modeling. They may want to see the financial impact of the need to spend money on marketing, product development, etc. Or, perhaps the operating company may need to cut expenses for profitability. The outcome of these decisions will require providing metrics such as EBITDA and breakeven analysis. These metrics will enable management to make the proper decisions to profitably manage the company.
Consider a Sales Director
A Sales Director is charged with establishing sales objectives by forecasting annual sales volume and profit margins for various regions, representatives, and products. The Sales Director also establishes and adjusts product pricing, monitors costs, meets competitive pressures, deals with economic indicators, and is cognizant of supply and demand. In order to properly price products, the Sales Director needs to know the component costs of each and every product to maintain a competitive edge and make a contribution above costs!
As the organization grows, the Sales Director’s job expands to include new territories. Financial modeling plays a key role by analyzing revenue sources and projecting growth, based on market size. Furthermore, the total dollar value of revenue generated, units sold, and average purchase value are key metrics to determine where sales reps need to spend their time.
The End Result
Financial models need to be flexible and live. As the organization grows, product lines expand and external forces impact a company’s direction; hence, financial models must be able to monitor these rapid changes.
Models will always produce an actual vs forecast results analysis, forecasting cash flow, and production of extensive KPIs and other analytics. This data is critical for the key stakeholders to manage business and calculate ROI.
In the end, financial modeling allows stakeholders to try before they buy and can prove how one decision can impact an overall business. Financial models capture the future operating, investing and financing activities that determine future profitability, financial position, and risk.