Why your business needs a financial model
Starting a journey not knowing where you are going can be fun if you’re an optimist and you like surprises. But in the world of business, it’s usually a good idea to plan where you want to go. This is where a financial model comes in.
FInancial models come in many different forms and varying levels of complexity. For most startups and new businesses, a basic model should suffice. Mature businesses, particularly those seeking external financing or investment, will probably require a more complex model comprising a range of scenarios and potential outcomes.
In simple terms, a financial model puts numbers to your business model and lets you know what profit you can expect to make. There’s an assumption here that your business has a basic business model. If that’s not the case you may struggle to create a sensible financial model.
This may sound like a lot of work and bearing in mind that working with numbers and spreadsheets isn’t most people’s idea of fun, why bother? Your financial model will help answer some key questions, which is why we think it’s worth investing the time.
Do you have enough capital?
The early stage of a business is often capital intensive and profits can take a while to realise. During this period your business will need a capital buffer until profits start rolling in. Amazon is famous for posting huge losses in its early years - but it had huge investment and a financial model that forecasted significant profits in later years ($10.1 million net income in 2018).
If you get this wrong and can’t finance the business when your capital runs out, you could end up having to wind-up your enterprise.
Will your business support your lifestyle?
Most founders need their business to generate enough income to pay themselves a living wage. Owners will often make sacrifices in the early days of a business in the hope that as the business grows they can reap the benefits.
It’s hard for a new business to predict demand for its products, but a good financial model will enable you to set targets based on where you want or need to be at a given time. If you don’t achieve these you can take action sooner rather than later - and avoid a nasty surprise when the money runs out.
What’s your best product mix?
Not all products are equal. If you have more than one product it’s important to know which are most profitable. At the start, it’s hard to predict which products will be most popular, so early estimates will need to be updated based on actual sales data.
Be careful not to include allocated (fixed) costs when comparing different products.
Have you priced your product correctly?
Pricing is one of the hardest aspects to get right. You may have a strong view about the correct price of your products, but ultimately the market will decide. Pricing and sales volumes do not always behave as expected - for example, a premium product priced too low may result in fewer sales.
Where will your business be in 5 years?
Five years may seem like a long time in business, but it pays to have an overall idea of where you want to be in the future. For example, do you plan to grow your business as much as possible in the first three to four years and prepare for a sale in year five? Or are you in it for the long-haul?
A good financial model won’t answer all these questions, but it will allow you to create a projection of your business’s profitability and overall financial position based on a series of assumptions. Not quite a map, but certainly better than an approach based on pure optimism.
If you’d like to discuss your business’s financial model requirements, contact Cow-Shed for an initial consultation.