Financial modeling

It struck me as peculiar that my accounting degree did not include any financial modeling. It was in the real world that I learned, initially as a CFO, and then in finance.

As a working capital financier, you see plenty of cash flow projections. Working capital finance is usually needed because people have made mistakes with their modeling at the outset. Financiers have to have own models into which they plug the numbers. It’s better than trusting the sanguine figures that are usually presented.

So that’s what we did.

As the spreadsheet guru, I was tasked with creating a model that integrated the balance sheet, income statement and cash flow projections.

Getting all three to balance is tricky, but crucial. Errors in assumptions become evident as the ratios go out of kilter, and that let’s you know if the numbers can be trusted.

Once the model is working, the starting point is to enter the last three months figures. If the assumptions and calculations are right, the most recent balance sheet will pop out from the input. If it doesn’t there are errors. Fix them, and you’re on your way.

The assumptions are key. They will guide the strategic planning, and the executive that has a grip on them is likely to succeed.

One of the best tools for getting a feel for the key factors in a business is also one of the simplest: break-even analysis.

To the uninitiated, break-even analysis is like a magic trick. Sitting in a pub, you can scribble down the variable expenses, then the fixed expenses, calculate the contribution, and tell a desperate friend why his business is struggling, and how long it will take to fix.

The financial model must include the results of a proper break-even analysis. Then, slotting in past figures will immediately reveal any misallocation of fixed and variable expenses.

The exercise of entering past figures has another benefit.

It provides the executives with confidence that the model works, and the understanding that by continuing to enter results they will know in advance whether something is out of line.

They become proactive.

They look good.

They are good.