Business owners can be unpleasantly surprised if they don’t have a way to predict future financial performance. Monthly reviews of your financial reports are a start, since they identify trends in revenues, expenses, profit margins, etc. However, they won’t give you everything you need to analyze financial trends, predict what to expect over the next 12 months, or assess the impact of major strategic opportunities. This is where financial modeling comes in. Rather than get all technical on you, let me describe a couple of scenarios and what we did.
Scenario One: Cash Flow Issues
A small(ish) marketing service firm was in a tough financial bind. The president of the firm had been feeling great about the direction of the business. Clients were beating down the doors, and based on history they should have been flush with cash. Then the financial manager came into the president’s office, and informed the president that the company needed an extra $40,000 in order to meet payroll and pay bills. This was a crushing blow, and raised serious questions. Was the business model broken? Would they need to close the doors?
We created a spreadsheet-based financial model for the firm. The firm had been successful for several years, and we had pretty good financial information as input. The model demonstrated how the firm made money, how it spent money, and how cash flowed. The financial model showed that profitability was not the problem – it was cash flow. The firm had had a very slow period about 4-5 months prior – major ups and downs are not uncommon in their industry. Projects typically took about 2 months to complete, and some of the large clients were slow in paying. Their cash flow problems were a result of the slow period several months prior, and not a reflection of a broken business model.
In order to avoid similar problems in the future, we developed a financial model that could predict revenues and cash flow based on various assumptions. We reviewed and updated the model on a monthly basis, and used it to track profitability trends, keep enough cash on hand, and make better business decisions. 15 years later, the firm is still in business and doing well.
Scenario Two: Increasing Company Value
The owner of a recycling firm wanted to sell the firm in the next few years. In the meantime, he wanted to keep growing the business and to create a good financial story for prospective buyers. He also wanted to assess options for expanding the business, and particularly how they would impact the value of the business. The business was highly seasonal, and the owner felt that it would be difficult to make financial projections.
The firm had several years of financial records, but these records were not in great shape. They passed the muster from a legal perspective (no hanky panky), but were shoddy in terms of how revenues and costs were categorized. Together with the firm’s owner and accountant, we identified major problems and cleaned up the financial data. We then analyzed the seasonality of revenues and expenses, and were able to create a fairly accurate predictive financial model. This was particularly important since the owner relied on quarterly cash distributions to help pay for his children’s college educations.
We then used the financial model to assess different options for expanding the business, and specifically how each option impacted the value of the business over a two year timeframe. The owner chose the option with the highest chance of generating revenues and profits over this timeframe, along with the lowest business risk.
About 18 months later, the financial model showed declining profit margins into the future due to the increasing costs of source material. This was a major concern while the owner was looking for a buyer, since lower profit margins would significantly depress the value of the business. We tweaked his pricing to get profit margins back to historical norms without hurting revenue growth. Six months later the owner was able to sell the business at his dream price.
Financial modeling can be a powerful tool for assessing the financial health of your business and increasing its value. Creating a financial model is simpler than you might expect – a model for most small and medium businesses can be created, tested and reviewed in less than a week. Create a financial model for your business and you will gain insights that lead to higher profits, less financial stress and increased company value.