What is a model?
A model is a tool to forecast some or all of your business' financial performance. It is properly organized and structured to evaluate options, answer questions, make decisions, communicate with stakeholders and consider change. Generally, there are three essential elements:
- Historical data
- Prospective assumptions (variables)
These three elements are analyzed together to mimic financial components of your business. Each component is then projected as a time series and summarized. For example, the below image demonstrates a financial model that produces projected financial statements. This model can be used to illustrate the financial health of an organization based on the operating results, financial position, and cash flows.
The Case for Modeling
Why build a model?
There are countless reasons why you would want to build a financial model. While it is impossible to list every reason, several of the most common are listed below.
UNDERSTAND CURRENT BUSINESS TRAJECTORY
Building a model to project the current state of your business will allow you to:
- Determine if continuing down the current path will result in financial success.
- Review your current state to understand the existing challenges facing your organization.
- Establish a point of comparison (a "baseline" projection) for future sensitivity analysis and scenario development.
- Alleviate pressure to generate short-term success at the expense of long-term profitability.
EVALUATE AND IDENTIFY OPPORTUNITIES
Building a model will allow you to quantify the impact of perceived business opportunities. For example:
- Is there a certain area of your business performing well? Can you capitalize on these existing strategies elsewhere in the business? Alternatively, is one area of your business underperforming? Should you consider reallocating resources to inject some life or more properly align with strategy?
- Highlight the consequences of immediate short-term decisions on the future of your business.
- What is the financial impact of a change to pricing strategies?
- What is the impact of expanding into a new market?
- Can you afford to develop a new business line?
- What is the financial impact of changing the delivery methodology for your service or product?
- Is the acquisition of another business a good financial decision?
A model can help you develop plans to mitigate the risks inherent in your business. For example:
- If there is a market disruption, like a recession, what does your financial picture look like? What can you do to help lessen the financial impact of a recession on your business?
- If a new competitor emerges, taking away some of your market share, is your business still sustainable?
- Can you withstand breakdowns in your equipment or products that result in lost revenue and additional expenses?
- What is the financial impact on your business if your industry changes its rules and requirements?
- Can you afford a drastic change to the composition of your workforce?
IMPROVE DECISION MAKING
A model allows you to combine multiple variables into a realistic scenario and understand the impact to your institution. You can then change (or stress test) those variables to better understand the risks associated with a given scenario. For example:
- You are confronted with multiple revenue projections, hiring plans and capital programs. A good model allows you to mix and match each set of alternatives to find the combination that puts your institution in the best financial position. This can help justify the overall strategy and direction of your institution.
COMMUNICATE TO STAKEHOLDERS
A model can be used to communicate options and bring stakeholders to action. For example:
- It can be used as a vehicle for inclusive planning across the institution.
- Visualize impacts and justify decision making.
- Assists with a narrative that is needed to move stakeholders to action.