What is a financial model – and does your business even need one?

While it's impossible to see the future, financial models are the best way to understand what your business could look like in a few years.

If recent years have shown us anything, it’s that life can be unpredictable. It’s human nature to try to predict the future, but without a crystal ball, scientists, academics – and accountants – make use of models. You’ve probably heard plenty of chatter about models recently, likely in the context of public health measures and government funding and how it gives insight into potential scenarios, but what exactly IS financial modelling and when and how can businesses use models to help make decisions? Keep reading to find out.

What is a financial model?

In essence, financial modelling is a way to predict possible futures for your business. Usually, models do this by extrapolating data about how a business is running and the environment it’s operating in. Data used to make predictions in a model is called an assumption, because there’s no way of knowing if it’s still going to be correct in the future that you’re predicting.

While there are plenty of programs out there designed to create complex financial models, a standard Excel or Google Sheets spreadsheet and a bit of know-how is all you really need to build one (this is what we use at Project Alfred).

If you’ve ever played around with a spreadsheet for your business, you’ve likely done some basic financial modelling. Adjusting variables like ingoing and outgoing expenses in your cash flow forecast is a way to ‘model’ how these variables could impact your business – helping to guide decisions that affect those variables.

Why financial modelling is important for your business

The main reason most small businesses consider building a financial model is to raise capital, but they’re useful for SO much more than just attracting investors. You can use a financial model to inform strategy, simulate a scenario your business wants to plan for, and even find and address inefficiencies within your business. If you’ve ever had to make a big business decision and been nervous about its impact, a financial model is a great tool to back your decisions with some data.

The most common model a business might use is called the three statement model, which links its balance sheet, income statement and cash flow statement. Linking these allows a business to predict the effect that pulling various levers could have on a business’ trajectory, while also identifying areas where it might be getting stuck. Models designed to attract investors or win grants go into more detail; painting a picture of what your business might look like in the medium to long term, as they’re usually based on a business plan or market research instead of historical data.

We’ve put together four common scenarios to illustrate some different applications of financial models and help you decide if it's time for your business to build one. Keep in mind – these are just a few of the many ways that building a financial model can help grow your business.

Forecast model: Financial projection for investors

As any Shark Tank fan would know, investors want to see that a business has a working understanding of their products, their operations and the market in order to earn their investment. A forecast model is the best way to show this kind of understanding, as it illustrates all of a business’ moving parts and aspirations while outlining the plan for best and worst case scenarios. It’s basically a message to investors that you know what you’re talking about, you’ve got a plan, and investment in your business will be beneficial to both parties.

Keep Many businesses that are seeking funding will be just starting out, meaning they’re unlikely to have heaps of historical data to use as assumptions in a model. That’s not necessarily a problem, with most investors looking for a good foundation and business plan rather than precise predictions. Assumptions used to build a forecast financial model for investors can be a bit of guesswork, so it's usually worth talking to an accountant to find out what to include.

While these kinds of models aren’t super precise, it’s still important to base the assumptions being made on as much real world data as possible. This data could come from conducting market research, or from accountants familiar with your industry.

Forecast model: Financial projection for grant funding

Much like investors, grant programs are essentially looking for the most bang for their buck when awarding businesses with capital. Businesses need to show how they’re planning to use grant money as part of their application, and a forecast model can be a great way to do this. The kind of assumptions that might be used to win grant funding can also be speculative for newer businesses, similar to models made to attract investors.

The proposed budget for a grant application should address how the money will be used in both the short and long term, plus highlight how well the funding addresses the purpose of the grant. For example, a business applying for a grant designed to grow local employment or strengthen the tech sector should demonstrate in their model how they plan to do this.

Scenario model: How companies can get smart about raising prices

Something that’s pretty common in the tech world is the founders starting off with one idea and a vision Models can also be used to study how a particular scenario will affect business finances, or answer specific questions about how prepared a business is for change. A scenario that many business owners will be familiar with is deciding how to price products or services. The assumptions used to model a scenario like this would usually be based on historical data, with tools like the three statement model able to simulate the effect of a price change on the rest of a business' books.

Businesses will generally model a few possible scenarios, and can add different sets of assumptions to create a more complex, but possibly more accurate model. Variables like consumer confidence, real wage growth and levels of discretionary income will all influence what impact a price change could have on business performance, but modelling these factors is much more complicated than a three statement model based on historical data. So if you’re thinking about building a scenario model for your business, the level of complexity you plan to include will impact the value of its predictions.

Operational model: Growing your workforce

Similar to a scenario model, operational models aim to find the immediate effect that changes will have on business finances. A financial operational model is much more comprehensive than a scenario model though, as it simulates the business’ books in as much detail as possible and in real time (this means it’s imperative that your books are up to date).

Maintaining an operational model is pretty resource intensive, so they’re mainly used by larger organisations, but they’re a useful way to decide where best to invest resources for maximum efficiency.

In our first year of business, we’ve spent a pretty considerable chunk of time making small process Take hiring, for example. A complex financial operational model could find the long term impact of growing your team by weighing up the cost with the projected boost in productivity. It could also help a business decide the best time to hire by identifying quieter periods in the year that could be used to onboard new staff.

Want to learn more?

Anyone can learn to build a financial model, but when you’re busy growing your business it may not be the best use of your time. If you’re curious about how a financial model could help your business take its next big step, let’s talk.