Financial models sometimes don’t start out life intended to be a full-fledged financial model. You might start fiddling in Excel, and go from there. In its most basic form, a model might start its life as a rough calculation or a “back of an envelope” scribble – something that can help you make the most basic of financial decisions such as; how much money do I have left when the bills have been paid? Those useful little calculations that help you plan whether you can afford to renovate your house.
Those envelope scribbles would include calculating your income, deducting your expenditures and helping you to work out the best approach to taking on a new renovation project. They would also allow you to understand how much you can afford each month to pay off an extra mortgage. You may do the maths and decide that it would be more sensible to wait a little longer and purchase a new house instead. Key factors impacting the decision could be: how long will it take you to pay back the loan? Would it be better to rent somewhere instead?
As you apply it in a more complex situation, for example: starting a new company or product line, your financial model requires a much more advanced approach. As well as considering cash flow, you’d expect the financial model to include information such as operating costs, tax liabilities and potential future developments. In this example, the model will allow for a more informed decision to be made regarding your approach.
Effectively, financial modelling provides a basis for control over the finances within an undertaking, project, or business. Often, a financial model is used for the same company and the same project but for different purposes. This can be for the purpose of evaluating feasibility from the inception of an idea to tracking results during operations, through to reporting and reviewing:
- Inception. A financial model should be used at the inception of a project as a forecasting or estimation tool. It allows best estimates to be captured and a business case, or feasibility study to be established. It can also be used as background support and documentation to the investors or banks when sourcing the funding for a project.For example, you’ve got a great idea to launch solar powered skylights.You create a financial model in the form of a business case with the estimated costs and revenue in order to convince the company board members to give you the go-ahead and the bank to lend you the money.
- Operational Delivery. Once a project is underway, the use of a model to track and report measurable revenues, costs and other metrics such as hours and KPIs can ensure that the undertaking is performing within agreed time deliverables. When used properly, the model will flag when there is an issue, allowing for decisions to be made to get the project back on track.You’ve launched our new range of skylights. You use the original business case to build a project budget and build a financial model to track actual sales, costs and staff effort against the budget.
- Closure / Review. When a project has been completed or we come to the end of the financial year, a financial model may be used to perform the usual annual end of year financial review or project report. Alternatively, it could also be a financial review for considering the future of a project or program; reporting to confirm whether the delivered return on investment or other metrics have been met and to determine whether it should be continued.At the end of the financial year, you’re asked by the board to create a year-end summary to check how your project went over the past year compared to the budget as well as to the original business case. Your managers will use this information to assess your performance and the project’s performance to decide whether to invest more in the project and whether to give you a bonus!
Be Careful! This kind of situation where you are building different financial models for the same project means that instead of re-creating an entirely new model each time, you will most likely re-use the same model again. For example, once you’ve created the business case, and you need to do an operational model, you’ll probably save the business case model as a new version and start building your operational model from there.
There is nothing wrong with this approach, as long as you are very careful to review all assumptions and calculations in detail to make sure that they are relevant for the new model. For example, you might have added in some contingency as a separate line item into the business case just to take into account additional items you have not accounted for. Once you have entered more accurate amounts for each line item in the operations model, there is no longer any need for contingency, so make sure you haven’t inadvertently included the contingency line item in the operational model.
A strong model and solution allow for the consideration of different variables and how they will affect the delivery or end goal/target status, providing the opportunity to react.