When small businesses or solopreneurs approach me to help them create a financial model, they usually have the same reason for needing one: investors want well thought out financial projections included in the business plan. Although this is true – investors do want to see financials projected for the next three to five years - there are a multitude of other reasons why a business (especially an early-stage business) should create a financial model.
Too often, I see passionate, talented entrepreneurs put all of their energy and focus on the product, and, for the most part, ignore the financial aspect of their business. Sometimes, it’s because the entrepreneur feels that if he or she perfects the product, everything else will work out.
Other times, it’s simply because the entrepreneur uses the excuse that they’re not a finance person (“I was never good with numbers” is the comment I always hear). However, no matter what the excuse may be, many businesses will fail if they ignore the value that a financial model can bring to their business.
Cash planning – making sure you can survive
For any early-stage business, the priority is to ensure that you have enough cash month-to-month to survive – which is why many early-stage businesses choose to build a 36-month financial model rather than a three to five-year financial model built out on an annual basis.
Besides merely projecting monthly cash balances, building a 36-month financial model forces an entrepreneur to think through the expenses they will face, and assess how much volume of business will be required to pay those expenses.
I recently built a 36-month financial model for a plastic bottle manufacturing company that had a very innovative process to offer premium bottles at a lower cost. Their team was extremely methodical with how they estimated expenses. Not only did we develop robust estimates for approximately 75 expenses, but we also predicted growth (if any) of each expense, as well as when a given expenditure would occur (e.g. was it an annual fee? A monthly expense?).
They ended up taking on roughly $1 million in debt from a bank, and successfully used the model to prove to the bank that all interest and principal payments would me made, even in a worst case scenario.
Projecting Return on Investment (“ROI”)
For the majority of businesses, all parties involved (e.g. the entrepreneur; investors) expect to make a return on their investment. There are a few examples of companies where ROI is not as important. One example is wineries – a business that isn’t very profitable, especially in the short-term; the entrepreneur running a winery is often more focused on living and breathing his or her passion rather than making a significant return. However, most businesses are not like the wine industry, as everyone involved wants to make money and lots of it.
Financial models are an excellent way for an entrepreneur or investor to judge whether a venture is worth doing. By projecting revenue, expenses, and cash flow, one can estimate the return on investment, which will be critical in deciding whether a venture is worth taking on. I once built a financial model for a successful solopreneur who was contemplating acquiring a majority share in a suntan lotion brand.
The qualitative aspects of the opportunity were attractive – the lotion was a great product, and it had a strong following with surfers in California. However, the solopreneur had no interest investing both his time and money if he couldn’t make a significant return on his investment.
Together, we went through all the variables that affect the suntan lotion business – seasonality, marketing/branding costs, manufacturing costs (and how they decrease as the volume scales), among many others. Once the model was built, he used it to estimate projections based on best and worst case scenarios, which ultimately guided him in his decision-making process.
What can you do with a given investment?
Usually, a financial model helps one estimate cash needs, which then contributes to decide how much money to raise. In other cases, though, a financial model can help a business estimate how quickly they can and should grow given a finite raise.
I once worked with a business that sells and rents shipping containers – a popular product for storage, in addition to shipping cargo overseas. The company wanted to grow as fast as possible but was limited in how much money they could raise from family and friends.
The business ended up taking the maximum debt they could raise, and then used the financial model to create a conservative schedule for capital investments. By keeping a close eye on estimated cash balances month-to-month, we set up a reasonable schedule for the number of shipping containers they should purchase on a monthly basis over a three-year period.
Evan Zawatsky specializes in offering strategic and financial guidance to small businesses. In addition to financial models, Evan helps businesses with business plans, pitch decks, market research, business model analysis, and many other projects that assist small businesses in achieving long-term success. You can contact Evan at email@example.com.