What is Financial Modeling?

Posted on June 24, 2015 By

Financial Modeling

What is financial modeling?  It’s creating a mathematical spreadsheet model that mirrors the business activity.  Why is it in a spreadsheet and not in a fancy online software program?  Each business is different and therefore needs a separate and unique financial model.  Generic budget software takes inflexible short cuts that can misrepresent the results.

Financial Modeling is a different way of thinking about business data.  Take a step back and look at the big picture. Should you be investing more capital?  Is a loan a great idea?  Is expanding to a new city a good idea? What is a realistic growth pattern?  How many touches do there have to be to acquire new customers?  What is the breakdown between repeat and new customers?

The spreadsheet models should be flexible enough so that projections and estimates will automatically adjust when variables are changed. In fact, the complex variables can be switched out and replaced on sophisticated spreadsheets.

There can be fixed step cost drivers, such as the need to purchase new machinery at a certain production level.  Seasonal fluctions can also be material.  For instance, holiday cards sell year round, but the sales increase from October to December.

Generic planning software does not readily adjust to those changes.

Location Expansion

Perhaps you would like to know what your retail establishment would make if it doubled the floor space.  It’s a bit more tricky than sales times two and voila!, your sales have doubled.  Some of the factors would be:

  • Capital improvements
  • Increased working capital to purchase additional inventory.
  • Advertising to attract more customers.
  • Hiring additional staff. (Payroll and Benefits)
  • New product line additions take research and time.
  • Increases/improvements to process more customers.  (cash registers)

That’s a lot of moving parts. Effective financial modeling allows you to make educated risks and choices.

Franchise Purchases

Franchises always look rosy when looking at the franchisers estimates.  However, let me tell you that franchises are just as likely to fail as any other type of business.  It can be even worse, because the franchisers prescribed store front, processes, and fees can put a heavy burden on any new business owner.  Doing an independent financial model to examine likely sales forecasts, franchise fees, payroll, and leases can be a boon and save hundreds of thousands of dollars.  That contract you are signing?  It might put you on the hook for additional fees that you can’t imagine while looking at that shiny brochure.  Hire an attorney to review the contract and hire someone like me to do a financial forecast.

New Venture and Feasibility Analysis

Bright ideas happen all the time. Following through on them is another thing. Make a plan to succeed. Effective financial modeling can tell if the venture will make enough money to succeed. Invest some time and effort to pulling apart the numbers before investing in a new business.

Adding Employees

When I ran my CPA firm, the thing that caused the most pain in marginally profitable companies was payroll.  The deadlines are tight, the taxes are high, and the late penalty fees were even higher.  It’s normal for businesses to bet the farm on increasing staff.    Do it in a sensible and sane way.  Crunch some numbers first and don’t make a bad problem worse by increasing staff numbers.

Yearly Salary Increases

Examining before and after results for salary increases.  How does it effect the bottom line or profit and loss?  Does it materially effect the overhead or manufacturing expenditures.

Overhead calculations:

QuickBooks and other generic small business software do not correctly calculate overhead rates.  There I said it.  Something that is completely obvious to anyone who does financial analysis, but no where to be found on any Intuit website.  It’s just not set up for it.  The software is set up to be east to use; not to create accurate manufacturing costs.  I know, I know they have the builds for manufacturing.  But if you open up the inventory builds section can you find the allocation for labor or overhead?  Oooo…. I have bad news for you then.  Your product cost is severely lacking two key elements for cost accounting.

We can help you track down those costs and do a proper allocation.

Economic Conditions:

Perhaps a large factory or employer is laying off employees.  You will need to see how that will effect the bottom line.  Or perhaps there was an economic slowdown in your industry. Or some other macro thing that will drastically change how business happens.

An example is the refillable toner industry.  For years it’s been profitable to refill toner for businesses.  However, with the advent of PDF’s and the increased ability to share documents online via dropbox, google docs, sharepoint, printing actual documents is rapidly decreasing.  The ability to scan documents in more effective manner is effecting the storage market, the legal market, and CPAs.

Business Valuation:

Buying an existing business is always risky.  Do some due diligence and examine how you think the business should perform vs. relying solely on the seller’s word.  Perhaps there are some hidden costs that could be teased out by recalculating the financials.  I’ve seen both paid and unpaid relatives providing for the company.  Perhaps all that unpaid work by a spouse, will be something that you need to replace with an employee.  Perhaps that might make a material difference in the company profitability.  Refigure the cash to profit turnover.  Maybe the AR is something that you want to negotiate.  Reconsider and redo that math a few times.  What if they are carrying old fixed assets that would cost 10 times that to replace?  If something is fully depreciated is it even on the depreciation schedule?  Business vehicles, how are they accounted for?  Personal ones?  Business vehicles?  Basically, you need to the turn the financials inside and out to determine if it’s going to be profitable, a good fit, or the asking price.

Schedule a free call to discuss more about your plans. 

 

 

Laura Dodson
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Laura Dodson

Laura Dodson, CPA is a Seattle Financial Planning & Analysis consultant.She has attended Western Washington University, Pierce College and Bates Technical College. She has written four accounting instructional books. She has worked for small family businesses, mid-sized businesses and a Fortune 500 company.She founded and operated Blue Stone Accounting LLC for five years.She currently runs Paper Butterfly Forge LLC.
Laura Dodson
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