Financial Modeling
Bill Warner Thursday, July 17, 2008
“Financial models are a black art and don’t really reflect what is going to happen anyway,” says a typical entrepreneur! Well, true and not true. It’s not a black art, and your business is probably going to act differently than you expected. Nevertheless, you can’t run a business without a game plan. When an executive and founder put a business plan together, one of the exhibits is a financial model of the business. This is your financial road map. It is important to show an estimate of how the business is going to perform over the first three to five years. It is shown as balance sheet, cash flow and income and expense statements. These are created from estimates of costs, expenses and revenue that all feed the calculations in the financial statements.
But, where does the executive get the data? There are lots of ways to go about this, but here is an approach that works pretty well, and in this order:
- From your market plan, do an estimate of revenue. Don’t just use a market share percentage and think you are done. Take into account the:
- Lead generation productivity expected
- The length of the sales cycle
- Price assumptions
- Revenue recognition assumptions
- Collection assumptions
- Availability of trained sales people
- Productivity of the supply chain
Calculate the number of customers per month and multiply by your price assumptions. Then calculate the revenue based upon your collection assumptions. Since so much of the cost and expense item are determined by revenue assumptions, this is the first step in creating a financial model. No, you won’t actually attain revenue exactly as you planned. The important aspect of this exercise is that you make reasonable assumptions to convince yourself that the revenue plan can be achieved.
- Based on the revenue estimate, the number of products and services sold is known. The costs of goods sold can then be determined. This is a matter of reflecting all the costs of manufacturing the product. For hardware, it’s the manufacturing cost. For software, it’s the cost of creating the software distribution package. For services businesses, it’s the costs of performing the service. Maintenance is also a cost item. These numbers will be subtracted from revenue in the income and expense statement to determine the gross profit.
As part of this step, the inventory plan should be created. Based on the expected rate of sales, a good estimate of the inventory and parts levels can be made. This will be appropriately reflected in the cash flow and balance sheet statements.
- Also, based on the revenue estimate, department budgets can be established. The task differs by type of department, and the expenses vary based on many factors; for example:
- The development expense of a product or service will have to reflect the workload required to produce it
- The maintenance expense will be driven by the inherent quality of the product
- The marketing program expenses will be determined by the number of leads that have to be generated to create the number of qualified leads that the sales team will need
- The sales expense will be driven by the number of customers that have to be called upon and expected closure rate
- The professional services department costs will vary by the length of each services engagement and the number of people that will be needed to perform them
- The support services will be determined by the expected number of customer calls that will have to be answered
- Administration expenses will be driven by the need for support for the functional departments; like sales administration, controller, legal, information systems, human resources, and many others
These budgets are laid out month by month and checked for reasonableness and completeness. All these numbers will be summarized and subtracted from gross profit, to determine the pre-tax net profit.
- Next, a capital budget is established, reflecting all the items that will be purchased that can be depreciated. These are usually items that cost more than $1,000. Examples are: computers, furniture, appliances, buildings, lease improvements, manufacturing equipment and telecommunications equipment. These too are laid out month by month and a depreciation schedule established. The expense for the capital will be reflected in the balance sheet and cash flow statements and the depreciation will be accounted for in the income and expense statement.
- Now it’s time to reflect all these items in the financial statements, which draw upon all the previous information. You will be able to see the profitability and cash flow performance of the business. But, you are not done.
- Unless you can bootstrap the business to profitability and maintain positive cash flow, chances are you are going to need money to get the business started. This influx of cash has to be enough to maintain a positive cash position at the end of every month. The main choices are:
- Borrowing – this form of funding is reflected in the cash flow statement and in the balance sheet as a liability.
- Strategic partnership – where another company supplies cash for your business and is returned a royalty on revenue once sales have been achieved. The nature of the business relationship will determine the manner in which it is reflected in the financial statements.
- Equity – is selling shares of the business to accredited investors who then own a percentage of the business. They get a return on their investment when the company has enough liquidity to repay their investment plus a generous return.
With all this information, you have a financial model of your business. Now you can understand the financial dynamics of the business and perform a “what if” analysis to tune the model. You should also compare your financial ratios with other companies that are similar to yours. This is a good check on the reasonableness of your assumptions.
With this level of financial work reflecting your business, you will have the basis for your financial plan. Not only will the model be used to convince yourself and possible funding partners, it will become your budget and revenue plan. This plan will be further refined as your business matures and learn more about your business’s actual operation.
Filed Under:
Bill Warner is the Managing Partner of Paladin and Associates, a business consulting firm in the Research Triangle Park area of central North Carolina, and is the Chairman of the Triangle Accredited Capital Forum, an angel investor network with over one hundred members throughout the southeast.
