7 Reasons On Why Financial Models Are Important

Creating Financial Models even for a startup business is very important to build a strong foundation regarding the financial identity of the company. Financial models for both existing companies and startups are the core element to take major business and financial decisions and the most important tools for business planning and execution of business decisions. Here are some of the most important reasons as to why you should prepare Financial Models for your business:

Reason 1:

Financial Models are created as an attractive financial representation of the company’s monetary situation. Basically, if you want to attract potential investors, you need to produce the best possible (and realistic) version of a financial model that will convey your financial forecasts accordingly.

Reason 2:

The main purpose of Financial Models is for planning the future of the company’s finances. It allows for more informed and better financial decisions within the company.

Reason 3:

Financial Models play an important role in Capital Budgeting. It mainly helps to determine the capital structure or cost of capital, as well as to create an analysis for resource allotment. For this reason, it offers a detailed review of the debt/equity system along with the returns expected by investors.

Reason 4:

Another use of Financial Models is to optimise the financial performance of the company. The most obvious use of Financial Models is to optimise the day to day operations of a firm. Companies use these Financial Models to determine how they can most profitably invest their resources and capital.

Reason 5:

For people working with investors, mergers, acquisitions, company executives, and related stakeholders, Financial Models is of great importance. The key explanation of why it is so important is that millions of Rands are on line with these big business transactions, and most of the decision-making comes down to the viability and believability of the Financial Models.

Reason 6:

Companies extending credit to Startups and Existing Companies bear a lot of risks if not properly assessed. Hence, they need to determine if the third-party is worth lending credit to can mostly only be done through a comprehensive analysis of the Financial Models.

Reason 7:

Not all startup businesses have the financing so, creating Financial Models is the best tool to attract potential investors.

In our vast experience in dealing with Business Planning and designing complex Financial Models for startups and existing companies, we have found the following elements are critical to be included in well-design Financial Models:

  • Sales Forecast – create a sales projection over the course of the period (whether for short-term or long-term planning).
  • Expenses Budget – create an expense budget plan as you need to have a better understanding of the cost you will expend to make the sales forecast plausible and feasible. At this juncture, it is important to remember all those potential “hidden charges” like staff training, marketing, PR. It is always wise to allow for/add a 3-5% contingency that will allow for any unexpected expenses.
  • Cash Flow Planning – develop a cash flow statement to track the flow of cash in and cash out of your business operations, partly basing it off your sales forecasts, balance sheet, and other assumptions.
  • Income Projections – or the so-called revenue forecast (profit and loss statement) for the upcoming years by using the sales forecast, expense forecast, and the cash flow projection.
  • Balance Sheet Projections – deal with assets and liabilities that weren’t included in your income projection to forecast the net worth of your business at the end of the fiscal year, especially for startups.
  • Breakeven Analysis – conduct a breakeven analysis after mapping out all the projections so as to assess if the business’s expenses match the sales or service volume. The analysis is conducted to measure when the business will reach the break-even point which is an important key for potential investors to refer to if the business is financially feasible and a good investment.
  • Calculation of Funding Required – preparing and showing the company’s required amount of funding is helpful if the management seeks to present this to prospective investors or any financial lending agencies.
  • IRR Calculation – businesses use this to calculate which discount rate compares the initial cost of the capital expenditure to the present value of expected after-tax cash flows. That is why IRR is one central component of capital budgeting and corporate finance.
  • Exit Scenario and Multiple – also, we should not forget to prepare an Entry and Exit Valuation. We need to carefully calculate and present an attractive Exit Scenario and Multiple to show prospective investors and compel them to invest their money in your company.
  • Shareholder Structure – lastly, we also need to show the existing Shareholder Structure, along with the percentage of equity and financing. This is very valuable data for prospective investors to assess the percentage share of the company’s equity.

Designing Financial Models may seem like a process that is simple and easy, but of course, the process is more than it seems. A lot of time is needed to be set aside just to build viable Financial Models. Not to mention that you at least need to have an acceptable amount of industry know-how to ensure the Financial Models are reliable and work the way it should.

Written by Dr Thommie Burger, Founder of Symmetry Hub Growth Partner JTB Consulting.

Established in 2006, JTB have successfully written more than 12,500 Professional Business Plans for clients across 25 countries. As a leading Business Plan Company, JTB delivers correctly structured Business Plans with exceptional quality every time.

Request a personalised business plan quote from JTB here.