Thursday, October 21 , 2021

How to Construct a Financial Model for Business Development

A financial model for business development is a tool to present a forecast about its financial performance. Startups and existing businesses make the most of these models and hire competent professionals to work out the best ones. 

No matter the challenges and significant data complications, the end product of financial modeling brings a lot of development. The projection formed on an MS Excel spreadsheet relies on the economic history of the firm. It also requires critical financial instruments such as income statements, balance sheet, cash-flow details, and other reports. Through this, more advanced types of models get generated like the Discounted Cash Flow Analysis, Mergers & Acquisitions, Leveraged Buy-Out, and Sensitivity Analysis. The output of financial modes serves as the foundation for business decision making or performing an economic forecast. The critical business development decisions that utilize the outcomes of the financial model are:

  1. Raising Equity Funds or Applying for Business Loan
  2. Organic Forecast of New Business Ventures
  3. Procurements or Acquiring New Assets
  4. Selling Assets
  5. Funds Allocation – planning ahead
  6. Estimating Business Value
  7. Performing Ratio Analysis and
  8. Managing Business Cash Flow

HOW TO PERFORM FINANCIAL MODELING FOR BUSINESS DEVELOPMENT

The best way to construct a financial model for your business is to identify and include its critical economic indicators. Suppose you wish to create a financial model by yourself. In that case, it will require years of practice and experience to produce the correct results. To achieve this, make a habit of reading equity research reports that can help you understand the comparison between different financial models and their outcomes. Another way of practice is to review recognized companies’ economic history, re-create their model into the future, and determine the current net value per share. It can also help you in comparing the present share-price/target-price value of equity reports.

To construct professional financial models, a person must master the skills of data analysis, forecast, budgeting, and excel. Knowing all differentiating insights of CPA vs CMA professionals enables people to decide about the career path well-informed. Thus, only those individuals with a dedicated mindset enroll for this profession.

Here is a systematic guide about where you should begin your professional financial modeling journey and how to connect all the dots finely.

  1. ANALYZE HISTORICAL RESULTS 

No financial model is possible without a thorough analysis of historical results. To construct a financial statement, you need at least three models to support the calculations and results ahead. Meanwhile, you would also need reverse engineering to make up a few assumptions about the historical period and calculate the figures. It may include revenue growth rate, variable & fixed costs, inventory costs, gross margins, and several others. These findings serve as the hard-codes of your future assumptions for the financial model.

  1. PRODUCE AN INCOME STATEMENT

After completing forecast assumptions, you can produce an income statement by employing Gross Profit, Operational Expenses, COGS, and Company’s Operating Performance. The operating performance gets evaluated through Earnings-Before-Interest, Taxes, Depreciation, and Amortization. It is a cash flow proxy for overall business operations.

  1. CREATE THE BALANCE SHEET

The third step is to create a balance sheet by calculating accounts inventory and receivables, which are the functions of cost-of-goods-sold and revenue generated. The next step is to fill accounts payable, which is the function of Cost-of-Goods-Sold & Accounts Payable days.  

  1. BUILD THE SUPPORTING SCHEDULES

A schedule for capital assets, debt, and interests are critical before completing the income statement and balance sheet. Property & Plant and Equipment (PP&E) helps pull from the historical period, adding and subtracting the capital expenditure and depreciation. In contrast, interest schedules are based entirely on the average debt balance.

  1. INCOME STATEMENT AND BALANCE SHEET

The data from the supporting schedule assists in completing the income statement and balance sheet. Add depreciation to assets scheduled like PP&E and interest-to-debt programs while making an income statement. This way, calculating earnings before net income and taxes become easy. By driving forward the past year’s closing balance, adding in the raised capital and net income, and subtracting the purchased shares or dividends, you can complete the Shareholders’ Equity.

  1. MAKE THE CASH FLOW STATEMENT 

It is time to build the cash flow through the reconciliation method once the income statement and balance sheets get fabricated. Take the net income, add depreciation to it, and fix the changes for non-cash working capital, which would result in capital from the operations. The money used in investments serves as a function of the capital expenditure in the capital assets or PP&E schedule. In contrast, the cash from financing is a function of the hypothetical scenarios about increasing debt and equity.

  1. DISCOUNTED CASH FLOW ANALYSIS

Once done with the three-statement model, it is time to perform a business evaluation and calculate the free cash flow. Any business entity’s free cash flow is discounted back to today at its capital cost, retirement rate, or opportunity cost.

  1. PERFORM SENSITIVITY & SCENARIO ANALYSIS 

After completing the Discounted Cash Flow analysis, it is time to add sensitivity analysis and prospect scenarios to the financial model. This analysis serves as the metric of the change’s impact. The company will feel if it goes through the underlying assumptions. This segment is also crucial to assess the risk factors involved with an investment or business growth planning.

Scenario analysis tends to predict a future event for a business and anticipate the agents of risk associated with it. It is also essential to highlight the possible opportunities that may hinder developing the firm to achieve its goals. Data gathered through industry surveys or questionnaires constitute a scenario.

  1. INCORPORATE CHARTS AND GRAPHS

To communicate every information clearly, you need to incorporate charts in graphs into your model. This advanced excel feature adds value and elaboration to your financial model, which is vital for creating a systematic presentation. Most business personnel do not have the time to look carefully into the numbers of your model. Hence, charts and graphs play an integral role in effectively communicating the script.

CONCLUSION

Constructing a sound financial model is the first step towards successful business development. Ensure that your model is free from human error or wrong citations by testing it to extreme limits. It is also crucial that you use fundamental auditing tools to ensure accurate application of formulae, generating correct results.

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