A Financial Model is one of the most important components of Business- and Strategic Planning. A Financial (Projections) Model has become the standard financial-decision making tool used by entrepreneurs, financial analysts, investors, business executives, banks and other stakeholders.
Financial Model 101
Financial Model Design takes time, effort and industry know-how and rationally looks at things free from emotion and personal attachment.
Financial Model Design ― Principle #1:
Starting a New Business: When building something new, risks are involved. One way to reduce the risks is to do some solid planning and (really) think the business concept through. For startups, this means preparing a financial plan as funds are tight, and many questions need to be answered:
- How much funding will be needed?
- When will we achieve break even?
- How can we monetise our platform, etc.?
So building a financial model can become a valuable planning tool for startups.
Financial Model Design ― Principle #2:
Raising Funding from Investors: One of the triggers why a financial model is prepared relates to fundraising. Many Startups will have to consider raising equity financing from investors such as Business Angels or Venture Capitalists. Investors are very critical people as their money is on the line. They will want to make a careful investment decision.
Therefore, they normally want to thoroughly review the investment case and understand the risks and upside potential before agreeing to inject money. This will require the business’ management team to prepare a detailed and well-substantiated financial plan that is credible enough to convince capital providers to proceed with the contemplated investment. Normally, the required calculations will require many details to be considered; therefore, a financial model in the form of a spreadsheet model will be needed.
Financial Model Design ― Principle #3:
Valuing a Business: Another reason is to value a business. The most famous example is the Discounted Cash Flow (DCF) Method, a forward-looking Income Approach valuation method. Future free cash flows are discounted to their present values by considering the risk and opportunity costs using an appropriate discount rate.
A DCF model requires at least a 5-year business plan. A detailed financial model spreadsheet in Excel is normally needed to prepare the required financial plan to perform the required calculations. As the financial plan is highly subjective, it is important to provide transparency about the assumptions, calculations and valuation method used. The best way to do this is to build these financial models in Excel.
Financial Model Design ― Principle #4:
Evaluating a New Investment: Here, we change the perspective from a company’s management or owners to an investor’s or buyer’s point of view. The buyer might be less interested in the valuation output; he needs to understand the returns, the risks involved and the upside of the proposed investment. This normally requires focusing the analysis on the Internal Rate of Return rather than the Net Present Value.
IRR analysis typically requires the calculation of the available cash flows to equity shareholders or a cash-in/cash-out consideration based on the investment amount, dividends, change in shareholder loans and associated interest and pro-rate stake in the exit value. To understand the investment proposition, investors will build their own financial model to determine how the projected profits and cash flows are calculated.
They also might want to play around with the model to understand certain scenarios, such as worst-case and best-case scenarios. Lastly, they might also want to compare the investment with past similar investment cases or current second-best alternatives.
Financial Model Design ― Principle #5:
Making Informed Financial Decisions: Financial decisions decide the allocation of funds. Every decision will have financial consequences and can either lead to a loss or a gain. Therefore, thinking about every decision and carefully running the required calculations is rational. A solid analysis will require a financial model as a basis for decision-making. Financial models are used to substantiate and justify financial decisions rationally and transparently. They provide a tool to quantify which scenario offers the highest financial benefit to shareholders (or stakeholders).
Financial Model Design ― Principle #6:
Financial Analysis and Understanding a Business: Developing a financial model helps analyse a business rationally and intelligently. Preparing a financial model allows the easy calculation of financial ratios since the calculations in the spreadsheet can be linked dynamically to the underlying accounts. Performing thorough financial analysis can identify problems with the business, offer new insights and allow a better understanding of the business.
Whenever something strange with a company’s financials is not understood, having a solid financial model as an analytical framework can help find the problem and solution.
Financial Model Design ― Principle #7:
Business Planning: A business plan analyses the market, competitors, Unique Selling Proposition, Strategy, and products and describes the plan in the future. A business plan will become more credible when properly quantified in a financial plan. Business plans are often developed or requested to become clearer, or agreement among the management team on how the plan going forward has to look.
A financial model quantifies the business plan in numbers and generates the corresponding financial projections over the next five years. A financial model, therefore, lies at the heart of any good and meaningful business plan and goes beyond a pure next year’s budget. The term “Business Plan” often refers to the 5-year financial projections.
Financial Model Design ― Principle #8:
Turnaround and Restructuring Scenarios: In the case of a Turnaround or Restructuring situation, a new business plan will be required, including the quantifications in the form of a financial plan. Entering into a restructuring is an important decision, and to maximise the chances of success, a solid strategy and some thorough planning will be needed. In many cases, a restructuring will require the allocation of capital. Therefore, a financial model as the basis for such decisions is needed to justify the decision towards the board or shareholders.
Financial Model Design ― Principle #9:
Bank Financing: Established businesses often have to raise bank funding for their investment or business expansion projects. Apart from collateral, banks typically focus on specific financial ratios, which are important to meet their lending criteria. Normally, these are Debt/EBITDA, Debt/Equity, and debt service coverage ratios. A financial model can model the expected financial ratios and their change when assuming a different business scenario.
Something Extra ― Never Use a Business Plan Template.
A Business Plan Template will not help you on your business journey. A business planning template can do more harm than good. You will regret it, and here are our reasons why:
Business Plan Template ― Danger #1
The individual/company is not willing to provide testimonials from previous clients they worked with (to support their claims of excellent service). Partnering with a consultant with recent (up-to-date) client testimonials is better than partnering with a consultant with few or very few testimonials. And yes, as the client, you have all the right to contact these past clients as part of your due diligence. Unfortunately, once again, false testimonials are sometimes used by individuals/companies to sell their services.
Do your homework and remember; that the transparency of the individual/company is key. You are more than welcome to view the 5-Star Reviews we have received on Google and the 40+ Professional Recommendations on LinkedIn.
Business Plan Template ― Danger #2
The individual/company claims excessive years of experience in the marketplace, e.g. can a consultant/individual that claims 100+ years of experience substantiate this? Is this the combined experience of the team members or the individual? Ask yourself the question: “If there are 2 team members, and they claim 150 years’ experience, it means, taking into consideration that both team members completed their schooling and university studies, they are 90+ years old! It is simple mathematics.
Business Plan Template ― Danger #3
The individual/company consistently use discounts and “being the cheapest service provider” as their claim to fame and marketing message. Or, they “will beat any quote out there”. Are we selling a new washing machine or a world-class business plan service here? Are we in the markets of Marrakesh where it is normal to haggle for the best price, or are you looking for a business plan company that will improve your chances of success?
Buying a service is different from buying a product. The age-old saying “if you pay peanuts, you get monkeys” has never been more relevant. Writing a business plan with a consultative approach and truly partnering with a client to reach a mutual goal takes time, extensive experience and know-how. And this comes at a cost.
Business Plan Template ― Danger #4
Review the client portfolio of the individual/company. Having experience in working with small, medium and large JSE-listed companies carries more weight than only having experience in working with micro-companies.
Business Plan Template ― Danger #5
Review the industry experience of the individual/company. If you are starting a new business in the South African Hospitality Sector, why would you use a consultant with only retail experience? It doesn’t make sense and comes down to your value as the client.
Business Plan Template ― Danger #6
Review the credentials, qualifications and experience of the individual/company/team members. Having an MBA doesn’t necessarily mean you will get world-class service. On the other hand, having very little or no Business Consulting/Management Consulting experience or experience in a non-related field will only cost you money, with no value to you whatsoever. Once again, transparency is key! If the individual/company can substantiate/prove the claims made with factual transparency, you are partnering with an ethical organisation. Many scam consultants are operating in Southern Africa. We have written a cautionary article on this topic to help our clients. Take a look at Afraid of SA’s Scam Consultants. Save R15K!
Business Plan Template ― Danger #7
Is the individual/company willing to meet with you face-to-face (even at a nominal consulting fee)? If not, why is that? Are they situated in Utopia, and will it be difficult to catch a flight to South Africa? Some clients prefer face-to-face, personal touch and interaction. And there is nothing wrong with that!
With this said, the increased cost of fuel and electricity and the time it takes sitting in traffic will justify having a production client meeting via Zoom or MS Teams. Why waste 2 hours each way to the meeting and R300 in fuel if you can have the same (or even better) meeting outcome in less than an hour?
Business Plan Template ― Danger #8
Is the individual/company providing a Specialist Business Plan Service or is “business planning” only one part of their service portfolio? Why would you partner with an individual/company that offers business plan writing as a service and services that have no relevance to entrepreneurship/business planning?
For example, an individual/company says, “We do business planning, but we also sell fish and chips and can check out your plumbing”. Partnering with a Specialist is better than partnering with a Generalist. Jack of all Trades, Master of None ― is that what you, as the client want?
Business Plan Template ― Danger #9
To claim to be a Leader and Specialist in a specific discipline/service/field is not merely including such a claim on your Website and marketing material. No! Research has shown that to call yourself a Specialist, you need at least 10,000 hours of experience in such a discipline/service/field. To be a Leader, you need to:
- Offer True Value
- Have a Tangible Value Proposition
- Know Your Market Inside-Out
- Lead the Market Through Consistent Quality and Excellent Service Delivery
- Have Substantial Client Testimonials and Recommendations.
So ask yourself: “Do I want to work with a Leader and Specialist or a Follower and Generalist”?
Business Plan Template ― Danger #10
Any financier and investor in South Africa will tell you that Quality is more important than Quantity. I have seen business plans that make a much bigger impact as a 10-page document and business plans that make no impact whatsoever as a 100-page document. An individual/company can promise you a 40+ page business plan, but what is the real and true value of the content?
Will it be 40+ pages that you can use for firewood Friday evening during the Rugby game, or will you be proud enough to present it to an investor? The number of pages in a business plan has no relevance whatsoever. So be careful of an individual/company that uses this as a “hook” to get you to sign with them. For more free advice, why not look at our free advisory article entitled 10 Alarming Reasons Why Your Business Plan Was Rejected?