This topic is one that is near and dear to my heart. I started working with models a few years back and I enamored with the idea that within a few moments I could find answers to highly complex questions. At the time I just thought it was interesting that you could play with data in that way, but as I learned over time these models are incredibly powerful, robust, and essential to any business’ success.
What has always surprised me is the multitude of entrepreneurs who have no idea how to begin solving their business problems or are oblivious to their business problem. My clients usually come from diverse professional backgrounds with little experience in finance, but they almost always have big problems that they are trying to solve but have no way to determine if those opportunities are valuable to them.
WHAT ARE FINANCIAL MODELS?
A Financial Model is just like any other model in that it is a representation of a real world phenomenon, but it is different because it usually represents a large cash expenditure and its expected consequences. At its core a model is designed to test some idea in order to see if it is feasible at a real world scale, and financial models are no different.
Before undertaking large capital projects many business will hire a consultant, or an analyst to help them determine the likelihood of project success, the consultant/analyst will then construct a model to show what the project’s expected results should be. Usually it is constructed as a set of forward looking (pro forma) financial statements and data tables created in excel that outlay what a company or project will look like given changes to certain variables, or assumptions.
WHAT CAN THEY DO?
Financial Models are used to do everything in business, from valuing opportunities to analyzing results, or from observing the consequences of buying another company to valuing an initial public offering.
Startups use them as a part of their business plan to entice investors, major corporations use them to evaluate new projects, investments firms use them to evaluate investment opportunities and the list goes on.
Small business owners who have the greatest level of risk don’t know what models are or the power in harnessing them to make strategic business decisions.
So let’s say you were an entrepreneur and you have to choose between purchasing a competitor or building your own manufacturing facility, you could model both situations and make the decision that converts to greater long term revenue growth for the company. Conversely you could create an operational model to help you manage the company’s finances. There are literally hundreds of uses but they are imperative to growing and sustaining any business.
At the end of the day, these are just models, and are subject to incorrect assumptions and poor projections. So be careful when using them, without knowledge of what you’re doing you can make a very expensive mistake.