All budding entrepreneurs spend long hours typing up a well versed strategy document for their new entity, as expected. However, very often there is insufficient time allocated to the crux of the business, the numbers.
Definition: Financial modelling is the process by which a firm constructs a financial representation of some, or all, aspects of its business.
For any new start-up entity the initial necessity for assessing potential returns on new investment or seeking external funding can be a daunting process. Whether you are soliciting funds from an institution, or a high net worth individual investor, the financial projections could make or break your deal.
Although you as the founder are naturally optimistic about the new venture, be mindful that most investors would rather see the worst case scenario. This allows the potential investor/banker to take a realistic view on the maximum potential losses, should the business fold in the first 12 – 24 months. As such, it is recommended to produce a low, middle and high road model, for a three to five year period.
Inputs and outputs
Most importantly, always keep in mind that your financial model is nothing more than certain inputs producing certain outputs. By designing the model correctly, a user should be able to change certain inputs to assess the impact of these changes on the related outputs (commonly referred to as a ‘what if analysis’ or ‘stress testing’ a model).
By way of a simple example, your sales revenue line for any specific month should be a function of the number of products sold, at a specific sales price.
For ease of use, both you and a potential investor should be able to adjust either of these variables in order to see how resilient the business model is, should your assumptions be incorrect.
Other basic recommendations when building your model:
- Create an assumption page, clearly defining any assumptions on which the model is built. By linking certain variables to the assumption page the model becomes robust and user-friendly.
- Be as transparent as possible, showing all formulae that lie behind calculations. This allows the user to easily follow logic through the model.
- Aim for simplicity and ease of understanding. Over-complicating a financial model with unnecessary worksheets can confuse and overload the reader.
- When inputting projected overheads, deal with each line item separately, without consolidating. This demonstrates detailed thinking, and allows discussion around each expense if necessary.
- The model should evolve with the business. You should be looking to check the assumptions made at the inception of the business, with the reality of what is achievable, after having the benefit of hindsight. By tweaking the numbers accordingly, the model becomes a more accurate prediction of the business in the future. This should be an ongoing process.
- Beware of attempting to use a generic template that may not apply to your business. Trying to customise these generic models could complicate a would-be simple model. Building your own bespoke model from scratch is the cleanest approach, even if assistance is necessary. This forces you to learn the intricacies of your model, which will hopefully stand you in good stead.
- Many books and websites recommend a myriad of options when it comes to building financial models. As a principle, lean towards the concept of simplicity, provided you are able to integrate your model into regular projected income statement, balance sheet and cash flow statements.
Are You Crunching The Right Numbers?
Measure what matters and you will find hidden money in your business.
Defining true profits
Just because you sell at a profit, is that enough to be profitable? A mistake that many business owners make is that they don’t factor in net profit when calculating selling price.
The natural tendency of business owners is to focus on sales growth rather than net profit. So, what is net profit? Profit is on paper — it is not in the bank. It is the money left over each month after deducting all the cost of sales and expenses it generates and subtract them from all the revenue it creates. Net profit is also calculated after paying a market-related salary to the business owners.
Identifying the winners
What are your profitable products or services, and which aren’t? Gross margin is the most important component of any business as it enables your business to pay its overheads, pay you and make a net profit to continue to grow and be protected from adverse economic times.
Gross margin is calculated by taking the gross profit, that is, the selling price less the cost of the product or service, expressed as a percentage over sales. Most business owners make the mistake of just measuring gross margins, and if they are being achieved, cannot understand why there is no money in the bank. To find hidden money, gross margins cannot be calculated alone.
Measuring cash flow together with gross margins for each and every product you sell or service you provide will determine which products or services make you money, and which don’t. For example, if product X has a gross margin of 33,3% and takes six months to sell, you have effectively lost your margin as money has been used to finance the product instead of being utilised to purchase more of the same products at a far higher turnaround.
Which customers make you money, and which don’t? You need to know how much of each product or service each customer has purchased from you and the gross margin earned on each of those products or services sold and how much money each one owed your business at any given time.
This analysis will determine the profitability of each customer. If your marketing efforts are directed only at those customers that give you a higher gross margin without also measuring the cash flow of that customer, you’ll be making the unwitting mistake of selling to some of the least profitable customers.
Unlike products and services, customers are people, some very nice, others either hostile or simply undesirable. If you have any hope of building a business that maximises profit, fun, and your free time, you should focus on attracting customers that respect you and your team, who allow you to use your full talents, are respectful of your time and have reasonable expectations and demands of your business.
If a customer does not resonate with you and your business, don’t deal with them, as they will invariably take a chunk of profit from your business, and that’s not a good thing, is it?
Return on investment
Your business cannot make money for you if your investment in assets increases at a faster rate than your net profit. The two assets we are concerned about are inventory and accounts receivable.
Let’s say your inventory and accounts receivable increases by R58 000 and your net profit was only R35 000 for the same year, you will not see money in your bank. Don’t fall into the trap of increasing net profit and ignoring your business’s overall investment in assets.
By measuring what matters, you’ll be amazed how you can find hidden money lying in your business.
What Makes a Good Financial Management System?
There is no one financial management system that works for everyone. However, every effective financial management system is based on a few simple principles.
Imagine for a moment you had the recipe to the best strawberry jam in the world. This recipe, a closely guarded family secret, has been passed down from one person to the next for decades. When people taste your strawberry jam, they are in raptures. They can’t get enough of it. Occasionally people even write poems about the stuff. People wait in long queues in the street just to taste it. And you’re the only person who knows how to make this product that brings in a limitless number of customers. Sounds like a recipe for success, doesn’t it?
Related: Not All Money is Created Equal
But imagine now for a moment that you have nothing to store your jam in. You have no jam jars or bottles or cans. You could make pots and pots of strawberry jam, but you have no way of bottling it.
There is simply no way to contain your precious jam. People arrive at your doorstep, eager to buy a bottle of the fruit-laden delicacy, and you have to turn them away. You offer a few good friends a lick off your wooden spoon, but you have no way of transporting any more than that.
Having no jam jars is a little like having a great business with no financial management system. You could have the best business idea, and the most talented financial staff to help you action it. But if there is no financial management system ‘containing’ the financial information of your company, then there is no way of keeping your business effective. Without a financial management system, your business is not much more than a big pot of jam.
We’ve combined our own ideas with some suggestions from Knowhownonprofit.org to help you establish good practice in the financial management of your business.
Your financial policies and systems must remain constant over time. If you establish a cash on delivery rule, for example, then your company needs to stick to that policy regardless of where you are in the cash flow cycle.
Your financial management system should create a paper trail that shows how resources have been used and who has authorized the decisions behind their use. Your system should create transparency, rather than make processes so complicated that it is difficult to determine who has done what.
The processes that your business adopts should demonstrate that your organisation values its financial resources and uses them for the purposes they are intended.
Compatibility with existing technology:
There are various bespoke financial management systems on the market, most of which come in the form of software, and all of which tout a complete financial management solution for your business. Before you spend many thousands investing in a system, make sure it is compatible with your existing technology.
What computers would be required to run the system? What level of training would employees need in order to use it? In addition, investigate who or what would be required to support the system, and at what cost.
Related: Do This to Improve Your Cash Flow
Accounting standards in South Africa are rigorous and extensive. Ensure that your financial management system complies with the latest accounting standards, and that there is a process whereby the system will be updated to reflect the latest changes, when they take place.
If you need guidance in implementing a financial management system for your company, The Finance Team can assist you. We have a team of highly qualified financial professionals who can provide you with part-time or interim advice according to your business’s needs. Together we can help you establish an effective system that will be the jam jars to your company’s secret recipe.
Written in the Financial Stars
The Art and Science of Reading Your Financials
Financial statements: Those thick boring packs of paper that you pay your auditor way too much to go over every year. The ones that come out six months after all the action has happened. Yes, the packs that collect dust in your cupboard because they are full of complex words and numbers that can only be understood by the partner that signed them off and the bank manager.
But what if this could be different? What if you could read and analyse your financials in a way that enables you to clearly recognise the past, understand the present and see the future?
Seeing into the future
Financial Statement Analysis is the process of analysing a company’s financial statements to gain an understanding of the financial health of the company and to enable better decision-making.
Financial statements only record data; proper financial statement analysis makes the data useful to the entrepreneur. It enables you to understand profitability and its drivers, to foresee cash flow and liquidity problems, to better manage your assets and resources and to identify and mitigate risk.
Sound a bit complicated? It doesn’t need to be. Starting with the basics, an entrepreneur can already gain invaluable information about trends and risks in his business.
Comparative Financial Statements: Calculating increases and decreases year on year
This enables one to see growth patterns clearly, and see the difference in growth of specific line items when compared to that of others.
Index Analysis : Choosing a basis year as 100% and stating all other years as a change in percentage
This is another simple way to clearly see growth patterns over various years.
Common-Size Analysis: Stating total assets in the balance sheet as 100 and showing all other line items as a portion thereof.
The same goes for revenue in the income statement.
This helps one identify line items that are material when compared to total assets or revenue. It is a nice tool to identify risk areas.
The above three methods can be applied equally effectively to both the income statement and balance sheet.
Once we understand the trends in our business and the composition of our financial statements we can get to the juicy stuff:
Ratio analysis is a number of different calculations that one can apply to financial information to obtain useful information and make valuable conclusions. They can predominantly be classified as and use for the following:
Liquidity ratios: Measuring the company’s ability to meet short term obligations (whether or not current assets are enough to pay for creditors and tax in the short term).
Solvency ratios: Measuring the company’s ability to meet its long term obligations (whether or not the company will be able to pay off its long term loan to the bank).
Profitability ratios: Measuring the company’s ability to generate profit from its assets (whether or not assets are being used to generate adequate revenue and profit).
Activity ratios: Measures how well a company performs its daily activities (inventory turnaround, debtors’ collection, etc.).
Examples of these ratios and pointers on their interpretation can easily be found with a quick search and have been excluded for the purposes of this article. But let’s make ratio analysis practical with one thorough example, using the net profit ratio (one of the basic profitability ratios).
Consider the following extract from an income statement:
At the first glance, the entrepreneur sees a healthy increase in income of around 40% per year. He also sees that profit has increased with 19% in 2013 and 31% in 2014, leaving him feeling quite content. But let’s dig a little deeper, using the net profit ratio.
Net profit ratio = Net profit/Income
Doing the calculation as above, the net profit ratios for each year, starting with 2012, decreases from 7,3% to 6,4% in 2013 and to 5,9% in 2014. This shows a negative trend, alerting the entrepreneur to look closer. He’ll see that his expense increase is stable at around 34% (less than increases in income), but that his cost of sales has actually increased by more than income (around 47%). Upon investigation, he has found that his cost of sales have grown so fast because his suppliers are asking higher prices, in turn because of their higher import costs due to the weakening of the rand.
Our entrepreneur realises that if he does not do something about his cost of sales structure, his business will soon be making losses because of the increases in cost of sales, even though his revenue is growing. This foresight will enable him to find better suppliers or to start importing himself in order to cut cost of sales, ensuring that his business’ bottom line will keep growing in future.
It’s no crystal ball, but good solid financial analysis has enabled him to see the future and adapt ahead of time in order to drive his profits in 2015 and beyond.
For some first-hand experience in financial statement analysis, come join one of our FREE financial function workshops hosted at the Bandwidth Barn on a monthly basis.
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