Developing a financial plan (i.e. financial model) is an essential step in the process of creating a comprehensive business plan, setting goals and evaluating the performance against those set goals. A financial model is a tool used to forecast future financial performance based on historical data and assumptions about the business.
Let’s face it, developing a comprehensive financial plan for a company is no easy feat. There are numerous factors that must be taken into account, such as:
- External factors: market trends, economic conditions, competition.
- Internal factors: the company’s own financial goals, operational processes, resources, capabilities and past financial performance
- Financial modeling capabilities: the ability to navigate spreadsheets with ease and code formulae that help you logically link operational processes and resources to their financial results.
- Past financial performance: a thorough understanding of the company’s past financial performance is also critical, which requires analyzing financial statements and other financial data.
Developing a comprehensive financial plan that accounts for all of these factors can be incredibly time-consuming and requires a significant skill and investment of resources.
To tackle this challenge, many companies turn to specialized strategy or financial consultants, if they can afford their services. These consultants are typically from Big 4 firms or similar, and are specially trained to develop complex spreadsheet models and perform financial analysis. They bring a wealth of knowledge and expertise to the planning process, helping companies develop a plan that is comprehensive, logical, flexible, and accurate.
However, the expertise and services of these consultants come at a steep cost. A single financial plan exercise can quickly cost $50,000 or more, making it a significant investment for any company. Despite the high cost, many companies are willing to make this investment, recognizing the importance of having a high-quality financial plan. A well-crafted financial plan can help companies achieve their financial goals, set clear targets for their employees, measure performance, identify new opportunities for growth, and stay ahead of the competition.
And after the consultants complete the financial model, changing it at a later stage becomes impossible for the company. The financial model was built in excel, by experts in financial modeling, so they made it quite complex.
Modeliks is here to change this narrative, and give YOU and everyone else with a small or medium sized business, or a startup, the ability to develop such a plan yourself, without being a spreadsheet expert and without depending on consultants.
7 steps to create a professional financial plan
Let’s now get started with understanding the financial planning process. We will cover the following topics:
- Identifying the Purpose of the Financial Model
- Defining its Structure
- Gathering Relevant Data
- Creating Assumptions
- Building the Model
- Validating the Model
- Sensitivity Analysis
By the end of this article, you will have a solid understanding of the steps involved in developing a financial model and how to use it to make informed business decisions.
1. Identifying the Purpose of the Financial Plan Model
The first step in developing a financial model is to identify the purpose of the model. What are you trying to achieve with the model? Are you looking to forecast future revenue and expenses? Are you trying to determine the viability of a new business idea? Do you want to set up targets for your employees? Are you planning to share it with potential investors? Will you use it to request a loan from a bank?
Once you have identified the purpose, you can then determine the structure of the financial model, the level of detail and complexity required. For example, a financial model used to evaluate the potential return on investment for a specific project may require more detail and complexity than a financial model used to request a loan from a bank.
2. Defining the Structure of the Financial Model
The next step is to define the structure of the financial model. This involves determining the level of detail you will want to have in your model, including:
- Length of forecasting period (usually 3 to 5 years),
- Monthly versus annual inputs (usually the first year has monthly inputs and the rest of the years have annual inputs).
-
Granularity of the outputs of the model
- Financial statements (profit and loss, balance sheet and cash flow statement)
- Other metrics that you want to calculate in order to evaluate the performance of your business.
It is important to consider what financial outputs are relevant to your business and to include them in the model. However, you should also be careful not to include too many metrics, as this can make the model unnecessarily complex and difficult to use.
3. Gathering Relevant Data
Once you have identified the purpose and structure of the financial model, the next step is to gather relevant data. Gathering data at this stage helps with knowing what data is available so that you can build your financial model based on that data. This includes historical financial data, as well as any other data that may be relevant to the model.
Examples of historical financial data include income statements, balance sheets, and cash flow statements. Other data that may be relevant to the model includes market research, industry trends, customer data and operational metrics.
It is important to ensure that the data you gather is accurate and reliable. This will ensure that the financial plan is as accurate as possible.
4. Defining Assumptions or Drivers
The next step is to define the assumptions, or the drivers of your financial model. Assumptions are the inputs into your financial model that “drive” the future financial results. This is why assumptions are also called drivers. Examples of business drivers include sales growth rates, gross margin, number of employees, operating expenses, etc..
Assumptions are the most important part of the financial model because they drive all the calculations and have the highest influence on the planned financial results. However, it is important to ensure that the assumptions are realistic and based on relevant data.
5. Building the Model
The next step is to build the financial model. You would now create all the formulas for calculating each line in your financial statements. All revenues, costs, assets, liabilities and cash flows will be linked with formulas to the assumptions, or drivers, that you defined earlier as inputs into the model.
Until now, this involved creating a spreadsheet that links all of the financial outputs of the model with the drivers (inputs) you have created. In order to build your model in a way that accurately reflects the realities of your business and its interdependencies, you will need to build in a significant degree of linkages and formulaic dependencies into your model.
Modeliks now allows exactly that, for you to build your financial plan based on the specific value drivers of your business, without the need of building your financial model in a spreadsheet and creating thousands of formulas.
Let’s understand what a driver-based financial model is and why it matters.
Driver-based financial planning is a process of identifying the key activities (also known as ‘drivers’) that have the highest impact on your business results, and then, building your financial plans based on those activities. When you can measure and influence these activities, you can successfully manage and grow your business.
Driver-based planning is important because it allows you to establish relationships between the financial results and the resources that you need to achieve those results (like people, marketing budgets, equipment, etc.). By connecting your financial plans to the resources required for each activity, you can allocate the right resources to achieve your goals.
Explaining this better, let me take you through an example. Let’s say that you have a SaaS software business, like Modeliks, with a target to achieve 1 million revenue next year.
The key drivers for reaching this revenue target could be the number of clients you need, multiplied by the average price a client pays for your software. But then, the number of clients depends on two different drivers, which are, the number of leads you need to generate, and the conversion rate from a lead into a customer. Now, the number of leads will determine how many sales employees you need.
The number of leads will also determine the marketing budget that you need to attract those leads. And, the number of clients will determine how many customer support people you need. You get the point. The 1 million revenue target drives a whole set of operational activities and required resources. A driver based financial plan allows you to logically connect all the operational activities and resources to the financial targets. And if you change your revenue target, all other resource budgets will automatically and logically change.
Finally, driver-based planning helps you set operational targets to your employees that they can control and feel accountable for. It also allows you to review your business performance along those drivers and know exactly which operational processes work well, and where you need to improve.
When building the model, it was always important to ensure that all of the formulas and calculations are accurate. You should also include clear instructions and labels to make the model easy to use.
6. Validating the Model
Once you have built the financial model, the next step is to validate it. This involves comparing the projections made by the model to actual financial performance.
One way to validate the model is to compare the projections to historical financial data. This will help you determine how accurate the model is and identify any areas where the projections may be too optimistic or too conservative.
It is also important to validate the model by testing different scenarios. This involves changing some of the assumptions and seeing how this impacts the financial projections.
Validating the model is an important step as it helps ensure that the projections made by the model are as accurate as possible. Before Modeliks, validating your model will likely have brought out many different coding issues in your spreadsheet model, which in turn take many hours or even days to fix. Today, with Modeliks, you can focus on what is really important – your business – and leave the technical formulae and background calculations, summary tabulations and balance sheet and cash flow calculations to the Modeliks tool to take care of.
Your validation work will move from fixing linking errors towards running different business scenarios.
This is the next level and the future of financial model validation, and will enable you to make informed decisions about the business today and in the future.
7. Sensitivity Analysis
Once you have validated the model, the next step is to perform a sensitivity analysis. A sensitivity analysis involves testing how changes in one or more assumptions will impact the financial projections.
Within Modeliks, you can run scenarios at the click of a button, whether you want to simulate increases or decreases in revenue due to changes in conversion or penetration rates, or by running profitability scenarios with varying marketing mixes and customer acquisition costs. All within Modeliks’ easy-to use interface, and presented to you with pre-defined charts that should cover 99% of your needs, while also giving you the flexibility to define your own output metrics and dashboards.
Performing a sensitivity analysis is important as it helps identify the areas where the business is most vulnerable to changes in assumptions. This will enable you to develop strategies to mitigate any risks and ensure the financial health of the business.
Final thoughts
Developing a financial plan is an important step in the business planning process, setting targets, and evaluating the financial performance of a company.
Up until recently, most financial plans were done in a spreadsheet. Developing a financial model in a spreadsheet is standard practice because most people are used to using spreadsheets. Also, there were no financial planning tools available (or affordable) to small and medium size companies.
Developing a high quality financial plan in a spreadsheet is actually a difficult and time consuming task:
- It requires expert knowledge of financial analysis, planning and financial modeling.
- It is prone to error. Linking thousands of formulas and calculations correctly in a spreadsheet is painfully difficult. There are always a few formulas that you messed up.
- And once the person that built the model is gone, it is very difficult for anyone else to understand what’s under the hood and make changes to the model.
The alternative to spreadsheets are financial and business planning tools like Modeliks. Modeliks solves the issues that come with using spreadsheets, while providing step by step guidance on creating a professional, accurate and thought through financial plan.
It is important to ensure that the financial plan is logical, driver-based and, as accurate as possible, because too many business decisions will be made based on that plan. You will set targets for all your employees and track your performance based on the plan. You will make investment decisions. You might even request funding based on it. There is too much at stake when creating a financial plan. Make sure you do it right.
