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Introduction to Financial Modelling for Entrepreneurs

by Olufisayo
Published: Last Updated on
Financial Modelling

Introduction

Ultimately, Entrepreneurs are on their own when it comes to running and growing their businesses. They need to continuously monitor their business and plan for the future.

A financial model is a great planning tool for a business when looking to the future.

Learning to create a financial model is a great skill for all entrepreneurs to learn. For some, that’s easy for others they will need to go on a financial modelling training course

In this post, we will introduce what a financial model is and the process of producing one.

What Is A Financial Model?

Simply put, a financial model is a numerical forecast for your business that lays out the forecast future performance of a business’s figures like revenue, sales, future growth, etc.

The one guarantee with a financial model is that it won’t be 100% right no one can forecast the future. However, when built with care, especially for stable businesses, financial models can offer a pretty good guide to the future.

Microsoft Excel, A Great Tool For Financial Modeling

Businesses vary hugely.

Different businesses have different sales cycles, working capital cycles, seasonality, capital structures, etc.

The differences between businesses are almost infinite which means that a pre-built model or template is never going to work very well.

Microsoft Excel is incredibly flexible. This means that it can be used to create a custom model for each business taking into account all its particular ways of doing business.

Also because Excel is ubiquitous it means that models can be shared and collaborated on very simply.

How a Financial Model Helps The Entrepreneurs

Entrepreneurs find financial models useful because they can:

  • Allow entrepreneurs to forecast future cash flow and ensure that their business is appropriately funded.
  • Analyze the operations of the business by assessing the cash flows, revenues, expenses, assets, and liabilities versus the forecast.
  • Be used to simulate different business options like expansion, launching a new product, etc.
  • Be used as part of a presentation to investors to attract funds into the business.
  • Financial models help compare your business with your competitors. By comparing with other similar businesses, you can benchmark your performance and better focus on your USPs.

How To Create a Financial Model

Creating a financial model is a large piece of work but follows a relatively well-established set of steps:

1.     Collect historical data

Models use historic business data to derive past financial ratios and performance that can be used in the model.

Ideally, you will have five years of data but three years can be used if five is not available.

2.     Calculate key performance ratios

From the past performance data calculate the key performance ratios that best describe the current state of your business. These ratios include gross margin, sales growth, inventory days, variable, and fixed costs, net margin, etc.

3.     Generate future assumptions

Now that you have the key metrics for the business’s past performance you need to build some future assumptions to build your model on. This will include future gross margin, revenue growth, inventory days, etc.

When creating these forecasts be sure to take into account external factors as much as possible. Examples of this include additional costs because raw materials are getting more expensive or taxes are rising, increased competition because of new market entrants, etc.

You should spend a significant amount of time on this part of the process.

A model is only as good as the assumptions that go into it. If you’re unsure about this part of the process see this article.

4.     Start forecasting data

In this step, you produce an income statement, balance sheet, and cash flow statement based off the assumptions that you generated in step 3 above.

5.     Visualising the data

Charts bring data to life. Once you have completed your model think about which charts would best communicate the key outputs of the model.

Different charts are best for different types of data. To access financial chart templates see this page.

Once you have completed the steps above you will have a clear financial model.

If you want to you are now in a position to move onto more complex analysis like sensitivity analysis, discounted cash flow analysis (DCF), stress testing, and auditing of the model.

Excel Skills Requirement

To create a basic financial model you will need intermediate to advanced Excel knowledge.

The types of formulas that Excel financial models use include:

SUM, SUMIFS Required to sum up different ranges of values, SUMIFS would be helpful to perform conditional sum operations
AVERAGE Average of values can be calculated, AVERAGEIFS can evaluate the range of values with multiple conditions
COUNT Used for counting the occurrences of values, you can use COUNTIF to check any specific condition
MIN & MAX Used to quickly find out the minimum and maximum values within the ranges
IF Function Can be used to evaluate different criteria. To evaluate complex criteria, nested IF can be used
Charts and Graphs Useful to convert plain numbers into meaningful and clear visualizations
Formatting Features Useful in managing the structure of the entire model like defining different ranges, using data validation, etc

Conclusion

A financial model is a great business tool. Especially for fast-growing businesses that need to take great care of their capital.

Leaving to work with a financial model in Excel is a key skill that all entrepreneurs need to develop as their businesses grow. It will help them understand how their business works and if they are appropriately financed for future growth.

Photo by Nataliya Vaitkevich

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