Financial Modeling: Part 1 – An Introduction to Black Magic

This is the first series of posts in a series on Business Development Essentials. These posts provide an overview of the fundamental areas of business management. Feel free to contact me directly should you have any questions or need help in any of these areas!

Financial Modeling is very often regarded as an obscure dark art practiced almost exclusively by bankers or accountants, and for some reason is perceived to have little relevance for ‘companies that build actual products’.

Unfortunately the first part is often true – and often this has quite serious consequences. Those who think that financial models are only useful for valuing a company or justify long hours in a bank’s offices largely underestimate their usefulness for decision making in literally any business. Therefore I decided to write a series on modeling basics to show you, in a nutshell, what it is all about. The posts will cover the many different uses of financial models in business and teach some best practice regarding effective and efficient model building. This knowledge will help you develop your own modeling skills and also judge those of others who may work with and for you.

Getting Out the Crystal Ball

Alright, so why do we need financial models for every sort of business? Simple: In order to run your business successfully you need to sometimes be a fortune teller! You will be expected to answer questions like this:

  • How long will your current funding last you?
  • How much revenue do you think you will generate this year, and in future?
  • How profitable are you really?
  • Are your costs growing at the same rate as your revenues?

Who wants to know these things?!, you might want to ask. Well, your investors, your employees (some of them at least), your competitors (if only!) – but most importantly: you do! And for those of you who now protest that their business is not-for-profit: you still want it to remain afloat, don’t you?

Financial models are able to help you answer these vital questions. They will not give you one universal answer (they are driven by assumptions, after all) but instead allow you to run a number of scenarios to demonstrate how your business will perform in each of those. That knowledge will give you a much better idea of what the future of your business will look like in that grey area between your best and your worst case scenario. Also, it makes you appear much more in control if you can demonstrate to your team and other stakeholders that you do not leave the company’s future up to chance – you have done your homework!

So What Do You Need to Get Started?

Of course you could do it all with pen and paper, but I strongly recommend you get your hands on some spreadsheet application. There are a number of options available, the most popular being Microsoft Excel, Numbers (Mac) or free programs like Google Docs or Open Office. While the choice is entirely yours (I will not get dragged into the religious war between Microsoft and Apple fanboys), I personally favour MS Excel. I have used it for many years and then tried Numbers, but found it to have very limited functionality compared to Excel. It works for some simpler calculations, but does not handle larger spreadsheets too well and I also find Excel to be more user-friendly. So if you are serious about building professional models, Excel has all you need.

Alternatively, instead of becoming a modeling star yourself, or tormenting your team to do so, you can get someone external for the job. This may be helpful if

  • your team does not have the skills to do it and it will take them too long to develop them
  • you need it to be done to a very high standard for an investor pitch (high quality is not optional here!)
  • you need to focus on your product and do not want to sacrifice resources at this point in time
  • it really is a one-off situation and you will never need to do it again (careful: wishful thinking!)

While I certainly think that all of those reasons are valid to bring in external help, you should make sure that this also includes some training for your team: at some point going forward (usually sooner than you think) you will be faced with a similar task again, and at that point you should be in a better position than you are now!

In the next post we will look at how to derive the framework and function set of a model based on its purpose – From Whiteboard to Spreadsheet

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