The beginner’s guide to financial modelling techniques for small business
Financial modelling is a term that rarely leaves the corporate finance world. It sounds complicated and honestly, it really can be. Traditionally the realm of financial analysts, it’s not something you’d associate with small businesses.
However, most people interested in growing their business will have conducted some form of financial modelling whether they realise it or not. It’s actually an obvious way to assess any important decision you need to make.
Firstly, to avoid any confusion, we are not talking about your business model. A business model is the method by which your company generates revenue and makes a profit. For example, here at Brixx we use a SAAS (software as a service) business model to generate revenue.
In contrast, financial modelling is a tool used for aiding strategic planning and decision making. It’s a process that is generally conducted by financial institutions or large corporations with dedicated financial teams.
It’s generally not conducted by people inside small businesses.
And that’s not because it isn’t worthwhile for small businesses. It’s generally because the process requires expertise and time not available to small teams. If those barriers weren’t present then it’s an activity almost any business could yield great benefits from.
In this article, I’ll introduce you to the world of financial modelling. I’ll run through the traditional methods for creating a model and what they are used for. I’ll also explain how Brixx, our software, can help unlock this process for your business by reducing the barriers to entry.
We’ll go over:
- What is financial modelling?
- The types of financial models and how they are useful for you
- How you’ve probably done some financial modelling already!
- How to create a financial model for your business
- Do I need to take courses in Excel and accounting?
- Financial modelling in Brixx
What is financial modelling? Making your business more aerodynamic
The basic principle behind modelling is actually quite easy to get to grips with.
Models in general are simulations that help people to understand something really complex. Something with a lot of moving parts. They are used in every industry imaginable, from simulating road traffic (to improve city planning), to simulating the movement of the planets (to plan space missions to Mars!).
Let’s take a look at really common modelling technique used in the car and air industry – wind tunnel simulations.
A wind tunnel facility allows engineers to push large volumes of air at speed over the chassis of a car. It allows them to test the cars aerodynamics. Better aerodynamics means more efficient cars, so it’s pretty important to test!
Engineers can see how their car performs when simulating different wind conditions and test the effect of changes to their design. This controlled environment accelerates their ability to find and fix problems. It also helps identify ways to improve far more rapidly. Attempting to understand the same factors in real world conditions is far harder. You don’t have control over these factors and so can’t easily judge what is the cause for any particular result.
Aerodynamics is complex and keeping the factors known and under control is key to understanding a complex system.
So, a model :
- Is a simpler version of a complex system
- Gives you control of the important conditions, metrics or assumptions
- Allows you to see how changes to these conditions affect a desired outcome
Financial modelling then, is like creating a wind tunnel for your business.
Your business is a complex system with a lot of interrelated activities. Financial modelling is a tool that can help your understand the financial ramifications of various ‘what-if’ scenarios.
The process of financial modelling involves building a simulation of your business where you control the factors. It’s an environment where you can stress test your business or try out changes that could improve its performance.
There are many uses for models though, let’s look at some examples.
Example types of financial models
Each example is used to help understand and make decisions around certain business goals.
The 3 statement model
A model that outputs the 3 core financial reports. This often forms the basis for the rest of the models. We’ll get to this in more detail later.
Sensitivity analysis model
A model set up to ask ‘what if’ questions. These test how sensitive the business is to changes in the market environment.
For example, ‘what if my supplier costs go up by 20%?’
This model would need the ability to adjust a ‘supplier cost’ variable. This would then feed through to the outputs so that the decision maker can assess its effect on the entire business.
Sensitivity analysis usually involves adjusting a single variable at a time to understand its effect on the model in isolation.
Scenario analysis model
This process involves creating a scenario from a range of inputs or variables combined together.
Many businesses will make three scenarios for a period: A ‘base case’, a ‘best case’ and a ‘worst case’ scenario.
A worst case scenario might choose a variety of key variables and look at whether the business can cope with all of them performing badly over a period.
You could create a scenario for any set of specific set of variables that help you plan your business. It doesn’t need to be limited by ‘macro’ or ‘top-level’ variables either. You can look at very specific cases like the timing of employing new staff or the effects of different product launch dates.
A model designed to help inform the company’s budgets for the coming period.
In this model, expense categories are broken down in more detail. It’s used to help assign limits and control spending based on what the company can afford.
It is often closely linked to a cash flow forecast to not only understand how much spending is possible but when as well.
Your budget model is often compared against actual results for the same period to keep track of targets.
Strategic forecast model
A long term forecast (often 5+ years). Simply put, this helps key decision makers see the big picture.
It’s a tool for making strategic decisions about company direction in order to meet long term business goals.
Small businesses often struggle to forecast 5 weeks ahead let alone 5 years! However, finding the time to do this activity occasionally can help you avoid the feeling that you can’t see the wood for the trees. Taking a step back to see the big picture helps you ensure the hard work you are doing day in day out is actually aligning to your long term goals as a business.
Getting locked into the daily grind is a real issue for small businesses and I can’t stress enough how useful it is to take some time out to think strategically at regular intervals.
Discounted cash flows model
A method used to look at the future cash flows of a company and discount them to today’s value.
This helps investors calculate their return on investment when assessing whether it’s worthwhile investing into a company or not. If you’re planning on approaching an investor, you may well have to get a lot more familiar with this model!
Other financial models
There are many other types too, such as an IPO (initial public offering) model, Merger & Consolidation model, LBO (Leveraged Buyout) model to name a few.
We are primarily going to be dealing with the 3 statement model in addition to sensitivity and scenario analysis. These are most pertinent to the day to day concerns of small business decision making.
Before I dive into the intricacies of the 3 statement model (which already sounds quite intimidating to the uninitiated), I’d like to preface this section by giving you some confidence in your own abilities.
The process of financial modelling is not about how much of a spreadsheet wizard you are. It’s about how well you know your business and the ‘drivers’ that will affect its performance and success.
As you’ll see, you probably know this stuff really well.
You’ve probably done some financial modelling already
I started this article by saying that most people will have done some form of modelling whether they realise it or not. That’s because you don’t make important choices randomly. At the very least you attempt to understand the primary factors behind any particular choice and how they might affect your business.
Small business owners generally don’t have the luxury to spend time forecasting the financials of every decision. Decisions are made based on the best information in front of you, in the here and now, and judged by experience and gut instinct.
In cases where you can easily run the numbers, this will often be done in isolation without looking at the entire business picture. It’s simply a practical approach.
Think about a marketing campaign you’re taking on. Figuring out if it’s worth the time and energy of you and your team usually means calculating it’s return on investment (ROI).
This means you’ll be looking at factors like campaign reach, conversion rates and average order values (to name a few).
There are a lot of complex factors involved here so you’ll probably have made some simple assumptions to make it easier to calculate the broad effects.
You might hypothesis, ‘My campaign can reach 1000 people, 10% will look at my product, then 25% of them will spend an average of £250.’ If you can predict the costs of reaching those 1000 people you can begin to assess the campaign ROI.
You’re simulating it’s potential. You might be making changes to the campaign details based on this simulation.
Perhaps you haven’t thought about it in these terms before but you are using the principles of financial modelling here.
The model of your marketing campaign is driven by certain key metrics and assumptions.
Now, when I say ‘driven’, what does that actually mean? What is a ‘driver’?
A driver is one of the key metrics (like campaign reach) essential to calculating your outcome (like ROI). In a model you adjust the drivers rather than interacting directly with the outcome itself. Any model starts by identifying the key drivers required to calculate the outcome you want to test.
This separation of ‘inputs’ and ‘outputs’ is a fundamental principle of financial modelling.
You could create a simple spreadsheet with formulas linking each of these metrics together and ROI falling out at the bottom.
This would be your marketing campaign ‘wind tunnel’.
With your marketing campaign model in place, you are free to simulate different outcomes based on how you think each metric could perform. You could make a base, best and worst case scenario to help judge whether you should approve the work or not.
Creating a model for your entire business
Now, this marketing campaign model is one activity in detail. Imagine you were doing this for your entire business.
The model of your entire business is also driven by key assumptions that drive an outcome. For an entire business, this is outcome is usually the 3 core financial statements.
These financial statements (Cash flow, Balance Sheet and Profit & Loss) are a common financial language across all businesses. If you understand them well, they can be used to project its future financial health and performance.
If you’d like an overview of what each of these reports consist of and show, we’ve written several beginners guides on this blog. Start with our financial report overview article here.
So the drivers in your model will be setup to output these financial reports.
Now, the drivers in this case will need to be simpler than the drivers for your marketing campaign model. You could theoretically breakdown your entire business into all its component activities. A driver for every single product, marketing campaign, employee etc.
In reality this will make your model too complex and unwieldy to build, manipulate and maintain.
Remember, an effective model must be a simplification of a complex system to be useful.
A useful model for simulating a complete business will involve drivers around categorised sources of income, costs, asset purchases and funding.
How these are broken down will be bespoke to your business. For example, you might identify that a key element to your success might be how much revenue you can make per employee.
To reflect this, your 3 way statements will need to be derived by more detailed information about the number of employees and product sales.
Other businesses might need to be less focused on this and could just have a top level driver for ‘salaries’.
The key is to keep things simple where they can be, whilst creating detail where you need it.
So, I hope you can see so far that modelling is not spreadsheeting. It’s simply knowing the important factors that go into your business.
Alright, let’s take a look at the 3 statement model in more detail. How do you turn 3 different financial reports into a simulation of your business?
The 3 statement model – what makes it a simulation?
Now, you’ve probably heard of these financial statements before in the context of historical accounting. If your historical data is well ordered (in cloud-based software for example) then it’s very easy to generate these reports.
However, just because you are generating these reports doesn’t mean you’re modelling.
Creating a forecast version of these reports also isn’t the same as modelling. The statements are the outcome of your model, not the model itself.
Earlier in the campaign model example I demonstrated that the model consists of metrics like ‘campaign reach’ and ‘average order value’. The output is ‘ROI’, which you never actually directly touch.
So the model of your business is a separate entity to the financial statements themselves. You never actually touch the statements directly.
To achieve this, traditional business modelling in the past has been done in a spreadsheet.
Your model is setup as spreadsheet page of assumptions and metrics linked by formulas. The financial statements are setup on other sheets, also linked by formulas.
This gives you the ability to make a change to the assumptions and see the financial results flow through the rest of the model.
Now we’re modelling.
Sure, this spreadsheet isn’t as inspiring as simulating the path of a spacecraft hurtling across the depths of space.
It is a simulation of your business though.
It can be pretty exciting when you’ve got control over the buttons and leavers responsible for hurtling your business along the complex path to growth and profitability.
If you can create an accurate, linked up model with the right assumptions relevant to your business, it’s an incredibly powerful tool for guiding your decision making.
Suddenly, you don’t have to guess the ramifications of a decision. You can go to your model and run the numbers to see the potential effects.
You can also demonstrate the business case for any particular scenario to your team. Your outputs are generated from inputs you can easily explain. This makes it far simpler to convince others that a certain choice is the right one for the business.
Is it time to take courses in Excel and Accounting?
Mapping how one financial action effects all three financial reports has generated an entire industry.
It’s called accounting.
It’s time consuming and requires experience and expertise. So, a model that automates this for you can really empower your small business. You can truly grasp the ramifications of different choices across the entire financial picture.
Unfortunately, to make the spreadsheet model I’ve been describing you need:
- Spreadsheet expertise
- Comfortable with formulas
- Comfortable linking multiple sheets together
- Comfortable with formatting large amounts of data to clearly present to others
- Accounting expertise
- Understand basic accounting principles
- Understand how the financial statements relate to each other
- Preferably a few accounting courses and qualifications under your belt
- Lots of historical data
- Understand the business inside out to know which drivers are key
- Maybe a background as a financial analyst for good measure!`
That’s an intimidating checklist. A completely unrealistic skill set for an entrepreneur to have.
How can you unlock some of the benefits of financial modelling without spending 5 years training to be a financial expert?
Let’s look at what we’ve established so far. Firstly:
Financial Modelling is not spreadsheeting.
Spreadsheets are a great tool but they don’t hold a monopoly over the process.
The problems stemming from the over reliance on spreadsheets are very well documented too.
They can contain errors that are difficult to see and track down. They are hard to understand if you didn’t build it yourself. They also aren’t easy to collaborate in.
Financial Modelling is not accounting.
Accounting knowledge is required for setting up a 3 way model from scratch in a blank Excel spreadsheet. An accounting background is also useful for understanding the different reports. However, if your model is clear then it should be easy to trace the origins of any number. If you understand where a number comes from then much of the reports become self explanatory.
For example you might see, on the Balance Sheet, a row labelled ‘Fixed Assets’ and see it has a value of £50,000.
A bad financial model will keep you guessing about this figure.
A good financial model will allow you to drill into that figure. This could reveal that the row consists of company owned vehicles worth £30,000, IT equipment worth £15,000 and other Office equipment worth £5,000.
Perhaps you’re unfamiliar with the accounting definition of ‘Fixed Assets’. However, being able to breakdown that number makes it such that anyone on the team can understand it.
So, spreadsheeting and accounting are not modelling. They are just barriers. They are only there because there hasn’t been a tool to make the financial modelling discipline more approachable for small businesses.
Our tool, Brixx, takes all the spreadsheeting and accounting out of the process. This means you can focus on modelling important scenarios and making better choices.
We built Brixx because:
- Small businesses deserve the same tools available to big corps.
- Business owners shouldn’t have to start a second career as a financial analyst to model their business
Financial modelling in Brixx
Brixx has all the important facets of financial modelling built into the software by default:
- A linked 3 way financial statement model
- Inputs and outputs separated into different areas
- Customise the model to make it bespoke to your business
- Report lines can be drilled into so you can trace and understand any number
- Cloud based with built in collaboration
You don’t ever need to:
- Spend any time building, testing or error checking formulas
- Spend any time creating or formatting reports
- Spend any time understanding the underlying accounting principles (although you’ll absorb a lot of knowledge just through using Brixx)
It looks like this:
Your model can be seen on the left with the resulting report output on the right.
The model is built from modular components that allow you to organise your business in the level of detail you need. Each component contains the controls required to power your scenarios. A component could represent a person you employ, a loan you take out, or a vehicle you purchase, or any business activity.
By using combinations of these components you can very easily simulate any scenario you want to model without touching a formula or knowing a thing about accounting.
Brixx isn’t just a financial modelling tool. It’s a time-based financial modelling tool. This means that each one of these components runs on an interactive timeline. You can quickly test time-sensitive scenarios like product launch dates, employee start times or marketing campaign durations.
All you do is drag and drop the start or end dates and since it’s a linked model, the results flow through all your outputs immediately. It’s the ultimate tool for testing scenarios that can take hours to set up in Excel.
You may not have a background in financial analysis or spreadsheet wizardry but with abilities like these, Brixx can make you feel like an expert.
Whether your goal is to make a long term financial forecast or to create a budget for the next 12 months, Brixx is a powerful tool that can make this process quicker and easier.
Getting started with Brixx
You can begin your no obligation 14-day trial by signing up here.