Financial Modeling Problem Definition
The first task in financial modeling is to define the problem or the solution that you need to propagate in your organization. Without a defined question or stress test, financial models suffer from the wandering path. Rather than searching for specific pattern or answer, they try to answer every single problem/issue that the business faces.
Zeroing in on a specific problem is not as easy as it might seem. Financial modeling is often the result of research, management meetings, and judgement calls. It’s much easier to update existing reports than to ask if those same reports are accurate and justified. Shaking up the status quo in reporting staff, is worth if new cost savings are found.
Start from the beginning if you want to break new ground.
What is most general way that you can define the problem? It’s helpful to even narrow it down a smidge. Last week, I had a meeting with someone who wanted to grow their budget by $2M. Which is all well and good. But what are you trying to accomplish with that investment? It’s easier for your team to develop a strategy if they at least know the basic theme.
It’s as basic as:
- Grow revenue
- Decrease shipping time
- Decrease product manufacturing time
- Increase gross margin
- Decrease shipping costs
- Vendor metrics
- Increase marketing reach
- Ship more products
Specific Financial Model
Create a specific goal for the financial model. This is where you start to drill down on the specific requirements.
- What is the projected gross margin of our existing products?
- Which project has the best NPV?
- What is an appropriate hurdle rate for new projects?
- Should we discontinue products?
- Why are the warranty issues so high?
- Should the capital budget be increased?
Develop Metrics and Benchmarks
Decide which and what stats are meaningful for your overall goal. Without a precise benchmark and metric, you might spend tons of time creating spreadsheets that do not speak to the goals or solutions.
For instance, an easy to acquire metric is how many twitter followers there might be. If you had a goal of acquiring a following of 1 million followers sounds like a peachy keen idea. However, what is the real goal? Isn’t it social reach or to become an influencer? Perhaps after doing a bit of digging you find that your social media team has purchased 800,000 followers. How is purchasing that many followers raising your company’s social marketing efforts?
Perhaps a goal of acquiring 200,000 live twitter accounts is more effective than purchasing 800,000 robot twitter accounts. Um. so you are thinking, but perhaps that is the same outcome? Having that many dummy accounts can actually drive off followers. When a person looks at a twitter profile and sees that the followers have ‘buy 5,000’ followers for $10.00; they can figure out that the followers have been purchased. They will move on without following you.
So if you need to develop quality metric instead of a quantity metric.
Another decision quandary is the processing time for monthly financials. Do you judge on the time it takes? Or do you judge on the quality? Is it better to have inaccurate results quickly or accurate results that take longer?
Many business processes are constrained by the time vs. quality issue. For example, do you order product from an overseas factory that might be cheaper but have greater flaws vs having direct over sight over the manufacturing process. Perhaps you determine that the factory does some work well, but not the finish work. Does it make sense to import the partially completed assemblies and then have the finish work completed near you? It might create a better product quality and give you time to customize the product so that you can quickly respond to market changes.
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