Starting a new business is an exciting prospect, but a company won’t succeed if the owners don’t create a financial model detailing how the organization will operate. Financial models help companies make important decisions about marketing and distribution, expenses, and overall business strategy. Additionally, a good financial model notes restrictions from loans and investments as well as top cash flow drivers.
To help forecast your company’s success or reveal obstacles to it, here are six secrets to creating the perfect financial model for your business.
1. Pay Attention to Expenses
Few businesses can turn a profit without investing in certain operational expenses. When building a financial model, it’s wise to start out by estimating costs for a given period. Typically, businesses divide their expenses into categories like costs of goods sold, payroll and marketing, among others.
A good financial model also considers both fixed costs, like rent and insurance, and variable expenses that change as a company becomes more or less profitable. Common variable costs include employee salaries and benefits, equipment, accounting and even federal and state taxes.
2. Assess Your Marketing Plan
It doesn’t matter how amazing your products and services are if you don’t have a detailed plan for marketing them to your desired customer base. When creating the perfect financial model, begin by examining the steps needed to move your wares from plan to client. Along with the costs associated with marketing and advertising to clients, a good financial plan should consider discounts, like sales and special offers, as well as affiliate fees.
Additionally, your model should account for the type of sales you can anticipate. Consider whether clients are likely to make a one-time purchase or become repeat customers. It’s important to note that the marketing component of a financial model changes depending on the type of business you operate.
For example, a business-to-business company will have a different marketing plan than a conventional retailer, so plan your forecasts according to your business type.
3. Take a Bottom-Up View
When creating a financial model for your business, it’s wise to start building your projection from the bottom up. A bottom-up plan focuses on operating expenses, and calculates spending by department.
Along with potential revenue, your bottom-up plan should factor in production expenses, hiring plans and turnover, as well as the cost of delivering products to your target market. This focus on tactical items allows for a more accurate projection by the entrepreneur and helps advisors provide better feedback moving forward.
4. Check Results from the Top Down
While it’s wise to build a financial model from the bottom up, savvy entrepreneurs seek to verify their results with a top-down approach. Using a top-down revenue estimate, a business examines the size of the overall market in order to forecast what share they can hope to attract.
Additionally, a top-down view takes into account whether a market is increasing or decreasing and looks at current competitor behavior. If your company can’t capture enough business to stay profitable, you may need to make adjustments to your product or create a more extensive marketing plan.
5. Find Your Break-Even Point
Even if you enjoy going to work every day, your ultimate motivation is to turn a profit. A crucial step in creating a financial model, finding the break-even point lets you know how much money you need to earn in a given period to cover your expenses and, ideally, take out a salary.
You can find your business’ break-even revenue with the following formula:
Break-Even Revenue = Fixed Costs / Gross Margin Percentage
After totaling the fixed costs for doing business, add up the gross profit margin (the percent of sales revenue the company holds on to after production costs). As the gross margin percentage rises, companies retain more of their revenue. Additional revenue can be used to purchase goods and services, pay off loans and debts or anything else the business needs.
6. Accept That No Model Is Perfect
Even if you take all the right steps when creating a financial model, the end result is likely to be somewhat inaccurate. But even if your inputs and results are off the mark, modeling a financial plan for your business can help you identify key influencing factors in your business. In the long run, the process of building a financial model helps you make better fiscal decisions moving forward.
Entrepreneurs often make the mistake of focusing only on the bottom line when creating financial models, but looking at business processes and past assumptions are just as important. The goal of financial modeling is to build a meticulous, monthly model that you can update as expenses and revenue fluctuate.
In the long run, the time you spend creating a financial model is likely to pay for itself in guiding better investments and choices within your business.
Good models need solid metrics to help illustrate trends and inform sound business decisions. To help your modeling efforts, here are five important metrics to follow.