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Why Do Small Businesses Need Financial Modelling?

There’s no way to predict the future, but financial modelling can help. This analytical process breaks down financial activity into a series of variables, allowing you to test each one to discover potential outcomes. Small businesses can weigh the likely outcomes of multiple actions using financial models, enhancing decision making.

What is financial modelling?

From start-ups to established corporations, financial modelling is a useful forecasting process for any business. Yet it’s particularly important for small businesses, who have slimmer profit margins to play around with. So, what is financial modelling exactly?  A financial model is any forecasting tool that looks at how your business will perform based on specific assumptions. Programs like Microsoft Excel and accounting software feature a series of built-in financial models to help apply these assumptions, changing them to examine cause and effect.

An assumption is simply an educated guess, based on your business’s past performance, industry data, and market conditions. The main idea behind financial modelling is that you can take these educated guesses, or assumptions, and plug them into different formulas to see how each would impact business performance.

Benefits of financial modelling for small business

Financial modelling seeks to answer questions like the following:

  • How would a product price increase impact profitability?

  • Would using a different supplier decrease manufacturing costs?

  • How would a wage increase impact company profits and employee productivity?

Financial modelling examples like these help small business owners make better-informed decisions to drive profit and growth. Using common models, businesses gain access to more accurate financial forecasts. Business owners can use financial models to:

  • Calculate start-up capital

  • Calculate burn rate

  • Compare different pricing models

  • Identify key business drivers

  • Model future expenses

Even the best-prepared businesses can face unexpected disruptions or challenges. A supplier might raise their prices due to disruptions in the supply chain, or your most important customer might leave for a competitor. By using financial models, you can analyse the impact of events to handle uncertainty more effectively.

Financial modelling examples

There are many financial modelling examples out there, so you can pick and choose the ones that apply to your business. A start-up financial model might be different from an established business. For example, start-up financial models are often based on industry data and market trends, because they don’t have any historic figures to work with.

Here are a few of the most frequently used financial models:

Three-statement model

This is the most basic (and important) model that you’d learn in any free financial modelling course. This model uses the income statement, cash flow statement, and balance sheet – the three financial statements – as its basis. You can use Excel or accounting software to create separate tabs for each statement, using a series of formulas and assumptions to forecast things like revenue, debtors, creditors, assets, and expenses.

What-if analysis

The ‘what-if’ analysis, also called the sensitivity analysis, is another important financial model to understand. While the three-statement model looks at your financial statements, a what-if analysis looks at the impact that changes to different variables would impact your bottom line. It analyses variables like supply chain costs, sales forecasts, delivery expenses, and selling price, changing them one-by-one to see how each would change your profit.

Discounted cash flow analysis

A third financial model to try is the discounted cash flow analysis, which forecasts the future value of today’s investments. It’s based on the idea that a dollar today will be worth more than the same dollar in several years’ time. Future cash flows won’t hold the same value, dollar to dollar, as money that you invest today, so you need to calculate this rate of change.

How to get started

If you’re completely new to financial models, one of the best ways to get started is by looking for a free financial modelling course online to learn the basics. Formatting is quite important for the accuracy of financial models, particularly using templates in Excel. You’ll need to distinguish assumptions from calculations to better analyse results.

There’s no need to learn every single model. Instead, you should pick and choose those which best apply to your current business needs and industry. Small businesses will often choose more customer-oriented models to learn more about customer acquisition and demographics. As your business grows, you can adapt your modelling accordingly.

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