A major part of running a business is preparing for the future. You’ve always got to make sure you’re ready to meet customers’ needs before those needs actually arise, and that you’re completely ready for any changes in the market or within your business. Of course, that’s easier said than done. It can be very difficult to plan for something when you don’t know the details – and when it comes to something as uncertain and ever-changing as the future, it’s impossible to ever know all the details. Right?
What is financial modelling?
In the simplest terms, financial modelling involves simulating the current conditions of your business to show you what its future is likely to look like.
Financial models are usually created in spreadsheet software, like Microsoft Excel or Google Sheets. They’re put together on an individual basis since they need to be tailored to the specifics of a business to be accurate. The reason they’re called ‘models’ is because they model – ie create a representation of – the behaviour of your business. By mimicking the patterns of your business’ outgoing expenses and incoming cash flow, these models can give you a clear idea of both your present situation and your immediate future.
In other words, financial modelling uses information on how you currently finance your small business (or are planning to finance your new business) to predict its future.
Why is it important to predict the future in business?
It’s not enough to understand the present if you want to succeed in the world of business. That may sound harsh, but it’s true. Startups and businesses that are only ready for the challenges and situations they’re currently facing can quickly go under in the face of unexpected changes – predicting the future can spare you from suffering that same fate.
To put it simply, predicting the future lets you get yourself fully ready for it. Your business can get its plans and legal documents in order, hire the right people, spend money on specific things, and save money in other places when it knows exactly what’s coming. This could inform business decisions such as where or how much to invest or whether to offer up company shares for private equity to generate more funds. To learn more about the subject, we recommend looking into how to conduct or prepare for a private equity interview.
You also need to know what you’re going to need going forward. For example, if you can accurately predict the debt that your business is likely to get into, you’ll be aware of your own need for a new Loan, debt repayment plan or other debt management tool ahead of time.
In terms of finance, you’ve got to know whether your business can handle the financial future before that future arrives. This keeps you ahead of the game and ensures nothing catches you by surprise. It may be helpful to use a financial Customer Relationship Management system (CRMs) to help your business manage customer relationships in your specific industry or field (eg a Law Firm CRM).
When do you need to project your business’ future?
Now that we’ve established how financial modelling works, you may be wondering at what points you would be likely to need this sort of functionality. The following situations are some of the most common ones in which you’d want to get a clear idea of what’s coming for your business – though, of course, there will be others as well.
When you’re starting a business
Because it involves data such as sales history or customer preferences, startups with no track record may think financial modelling is not applicable to them. But it’s important to make a plan for the future when you’re launching a business and to get into the habit of gathering and analysing data.
Instead of current and historical data, new businesses can use industry and market research to create a financial model. For example, you can look at other firms in your industry and carry out market research to set the right prices for your product or service.
If your startup is seeking investment, any potential backer will want to see a detailed Business plan—including financial projections— to check that your business proposition is viable. You should include your predicted operating expenses and plan for a variety of financial scenarios.
When you’re looking to scale up
Ahead of a major endeavour like an enterprise transformation, it’s always important to know exactly where you stand. Upscaling is no different.
Projecting the financial future of your business allows you to base your plans on facts. That means ensuring that the plans you do make are more likely to work out in your business’ favour because they’re data-backed and founded in reality. Small and medium-sized businesses (SMBs) in particular will want to be prepared to scale up, even if it isn’t to the extent that it transforms the overall size of the business. It’s always a good idea to be ready for business growth, after all.
At the start or end of financial quarters
Knowing your financial status as a new financial quarter rolls in helps you handle the challenges that come in that quarter more effectively. Each financial quarter is unique. They may follow a similar pattern, but since the world is always moving forward with ever-evolving technology, no two quarters can be exactly the same. That also means new difficulties will arise all the time, which you’ll have to be ready for. And after all, there’s no better way to ensure you’re ready than to simulate that future so you can see your financial situation for yourself.
During budget reviews
Small businesses in particular tend not to have the luxury of extra, expendable budgets. They’ve got to monitor their finances closely because they can’t afford to overspend. This makes financial modelling particularly useful to them during budget reviews.
Financial models use your current financial state to predict its future. Hence, when you’re reviewing your budget, you’ll want to make sure your financial model shows you a future you’re happy with – because if you’re not, that’s a clear sign something’s going wrong in the present.
Also, it’s useful to test changes to the budget in the model. This lets you see how those changes are likely to impact the future of your finances.
Anytime you’re preparing for changes
Not all changes are huge and super impactful. However, each one has the potential to create ripple effects – and that’s important to pay attention to, particularly in SMBs. Instead of simply implementing a change and hoping for the best, you’d be better off using your financial models to see whether your current systems can cope with the development you want to implement.
For example, let’s say you’re browsing for new communication tools. Before committing to a specific tool, you’d want to run your model to check that your budget can handle the new addition. If you see your finances dipping into the red in the future with the addition of a new tool, you’ll either have to give up on that option or look into adjusting your budget elsewhere.
Financial modelling best practices
We’ll round things off with a look at some of the best practices you should follow so that you can ensure you’re using financial modelling in the most effective ways possible.
Account for plenty of variables
When you want to set about starting a business, you would typically run a few checks. For example, you’d want to make sure you have enough starting capital, as well as the right resources and employees. Similarly, your financial model needs to account for as many variables as possible.
The short of it is that your business doesn’t exist in a vacuum. Your finances are affected by a wide variety of variables, from changes in seasons to online trends and well beyond. The more of those you take into consideration for your models, the more accurate those models will be.
The question of when to update your financial model can be daunting. What sorts of events count as being big enough to call for an update? Or should you be following a specific schedule?
An easy answer is to simply update your financial models as often as you can, within reason. A daily update is a bit excessive, for example… unless you’re using those models to create new predictions on a daily basis as well. In that case, it might actually be a great idea to log changes very, very often.
The reason why it’s so important to keep updating the spreadsheets you use to create your models is that your present situation is constantly evolving. In addition, you can create online invoices to keep track of your everyday costs. This means that without regular updates, your resultant model can quickly lose accuracy.
Remember that no model is perfect
Even the most accurate model in the world can be anywhere between slightly and very off when it comes to predicting the future. That’s because there’s always the possibility of a totally unprecedented event coming about – such as the pandemic in 2020, for example.
Your model is there to give you a clear and often highly accurate idea of the future. It’s always going to reflect your current reality accurately. However, you can’t rely exclusively on financial models for insights into the future. You should make sure to bear this in mind when creating business contingency plans.
The best way to address this is to keep in mind that your financial models aren’t your only window into the future. You can always use predictive algorithms, for example, to help you enrich your understanding of the next year or quarter.
Secure your business’ future with financial modelling
In order to future-proof your business, you’ve got to take advantage of the potential that comes with financial modelling.
Creating accurate models lets you develop a deeper understanding of the financial reality of your business. It also helps you determine how prepared you are for future challenges and endeavours, ensuring you never walk into the future blind.
So, to put it briefly, you need financial modelling to ready yourself for the future. That’s true regardless of the size of your business, but it applies particularly to smaller businesses, which are more likely to be strongly impacted by changes in their financial situation.