Do you use a financial model? What is it and how do you build a financial model? Is it serving you well in your business operations? Financial modeling is the task of building an abstract representation of your businesses’ real-world financial situation, and it is something that is crucial to the overall health of your business. Additionally, using KPIs as a measure of value will demonstrate how effective your company is in achieving those key business objectives. We want to share with you how to create this “roadmap” of sorts, so you can make informed decisions about your business, and know where your business is headed, in order to reach your business goals.
What we cover in this episode:
- 02:38 – Why do you need a financial model?
- 05:06 – Where do you get the information you need?
- 09:50 – What are the components of a financial model?
- 22:23 – When should you consider updating your financial model?
Why do you need a financial model?
Why is a financial model important and why does this topic matter for business owners? Financial modeling allows you to look at the financial viability of your business and improve the growth rate. A common belief is that it is similar to a budget and, while it helps with budgeting, it is quite different and plays a crucial role in business planning.
Your financial model helps you confirm that the business model is viable and will work long-term. This tool allows you to take a step back to look at the basics such as “my company does X, and we pay our employees X, etc…” Without this tool and the awareness it provides, business owners may be putting their heart and soul into running their business only to discover that it just isn’t financially sustainable. A financial model allows you to analyze all the core parts of the business and, according to Katina, “drives setting up your future goals, setting up your budgets and plans for the year.” These are the things that go into your strategic planning and ultimately what contributes to revenue growth.
Where do you get the information you need?
This is a common question for many business owners, and for most businesses that have been running for a while, that answer comes from the historical information within your business. Industry information can be another great place to look for guidance and can be used whether or not a business has any historical data available.
In order to build the model, you have to start with the basics. How many people do you think you need? How much should you think you need to pay them in the current market? There are many potential inputs but generally, you’re going to design it like a profit and loss statement, using revenues, expenses, and then you’re going to have some inputs coming in from other areas.
For service-based businesses, which are very team-driven, you don’t have any product necessarily going into the model. So the model is built around what our team members can produce. Katina said “When you have those team members, you use those KPIs and the kinds of things we’ve been talking about, such as, what should you be doing per team member? And then we also obviously have their related costs, like how much in payroll and benefits, and whatever else we need to add in, such as our tax burden, et cetera.” Katina continued, “So that all kind of plugs in then to our profit and loss model for the business.”
There are many different tools you can use to put this all together, but you can start by just writing it all down on paper and thinking through all the components. Perhaps you can export your current QuickBooks P&L (profit and loss) into excel as a starting point. You would then start tackling each item, in a similar way that you would look at each item in your budget, and focus on the specific items for the input side, and look at what your business is going to be doing. If your business goal for instance is to reach $2 million in revenue at a certain point, say 1 year, or maybe 3 years down the road, you have to figure out different inputs to get there and discuss revenues, staffing, costs of goods sold, overhead, marketing, et cetera.
We do recommend that business owners engage with someone who is familiar with the financial modeling process to help work through it since there are many components to take into consideration. You will want to avoid making assumptions as that can render your model unreliable. The assistance of an advisor will also ease the tasks of tying in the related KPIs, industry data, and historical data.
What are the components of a financial model?
The financial model starts with the revenue numbers and analyzing what you need to put into place to achieve your revenue goal. How many team members do you need, and how do you figure that out? That goes back to the related KPIs for staffing and analyzing the numbers and information from historical and/or industry data. Your information should tell you that each person that you employ can make X amount of revenue for you, on average. You can then narrow it down further and add additional information about geographics and areas where variables are different, such as cost of living differences and employee expenses, and account for the higher rates of certain employees. Additionally, you’ll want to consider the types of employees you have (professionals versus administrative, for example) and build those layers into your model.
Knowing your labor burden and plugging that into your model is the essential first step. From there, it’s time to take a look at the costs of goods sold or costs of sales, and related KPIs for your type of business. Typically, these numbers come from your historical percentages, and what we mean by that is the percentage that it normally costs you out of your revenue to pay for that line item, whatever that percentage may be. If it typically costs you 5% of your revenue to pay for that line item, then that’s the figure you tie into your model. And it can of course be changed due to many different variables. For instance, you may have gotten a market price increase, or have established a deal that you’ve negotiated with vendors to bring costs down. You’ll want to look at each line item and make sure those percentages are in line with expectations.
The other components that need to be taken into consideration next are the items typically posted on the cost of goods side, and things that are considered flat rate items. The more business you do, the higher those costs may be. Items such as administrative costs, office rent, office supplies, equipment, and insurance, etc. Maybe you’ve been operating on a shoestring budget in the past, so you want to put a little more money into software or technology to increase efficiencies. All of these items should be looked at in detail and considered when looking at the cost of goods side of financial modeling.
Modeling for the sales and marketing of your business is also a big piece of the puzzle for your financial model, and you should have a good understanding of the sales KPIs such as knowing how many leads you need to get to convert to a final sale, and what is your average revenue per sale. The traditional seven “P”s related to marketing are also key to financial modeling for your business, whether service or product based, and can be integrated into your strategy. Product, price, place, people, promotion, processes, and physical evidence all interplay with the approach you take with the marketing side of your financial model. You’ll want to make sure everything related to marketing is integrated into your overall plan.
When should you consider updating your financial model?
There are a few things to consider when you circle back to your ultimate revenue goal in your model. You have to consider if that number or goal is actually realistic and something you can reasonably reach and sustain. Your financial model is going to change as time goes on, but it’s really the basic structure of your overall business, and it drives your budget. You have to ask yourself if the model is something that will allow you to reach your goals and be sustainable. Do you need to make adjustments to create opportunities for additional growth and profitability? As a business owner, you should be thinking about all the pieces it takes to get you to your revenue goals, and using a well-crafted financial model can be key to your success.
When you are following your financial model, and getting the profit percentage you want from your model, you can confirm you are sustainable. But as most business owners know, things don’t always go as planned, and things that you may have assumed when establishing your model could change in the future. Things happen for businesses at different paces, and revenue can take time to build depending on so many variables. Building a financial model means to reflect what you are planning to do for multiple years, and can include your plans to take you to the next level. Once you’ve built a model and you’ve confirmed the accuracy, you can use that for budgeting and strategic planning.
The first time you create a model, you’re doing it based on your best knowledge. There will be things you didn’t consider and could be components that end up different in reality than you thought. The worst thing you can do is stick your head in the sand with your financial model. You want to make sure it still continues to work in relation to what’s actually going on in your business. The goal is that, after a few years or so of using the financial model, you’re going to nail down many of those things that may need to be changed in the model. The bottom line is that you want to be using your model actively and then adjust it, as needed, as major changes occur or after you’ve made a major change in your business.
Set yourself up for success! Whether you’ve been in business for a long time or not, using a financial model can help you run a profitable business and clarify for you what you really need to do in order to reach your goals and monitor your financial performance. Again, we encourage business owners to speak to an advisor with experience in financial modeling because they can assist with the oversight and even change the perspective for owners to really take a step back and see their businesses from the top down.
Please reach out to us if you are interested in talking to someone about financial modeling for your business, we would be happy to discuss that with you and assist. Don’t forget that we offer a free discovery call that you can book online or reach out to us at 844.475.7272.
Do you know where your business is going? The creation and use of a financial model for your business can be an invaluable tool for the success of your business. We establish the importance of a financial model, what exactly that is and what it can do for your business. We then tackled where you find the information needed to put this too together, as well as the components of your financial model. Lastly, we established the need for changes and updates and when those need to occur with your financial model. This is a crucial tool to reference before establishing strategies, budgets and goals. This tool helps you gain visibility around the viability of your business so you can make necessary changes and avoid wasted time on a model that isn’t sustainable.