Financial Modeling Can Help Management Make Better Decisions

Now more than ever, it’s vitally important to understand your financial condition and how future decisions will affect growth, profitability and—most importantly—cash flow. As you contemplate the impact of negotiating key supplier relationships, re-evaluate workforce, and make decisions on capital expenditures, you need to understand the impact each has on cash flow. It's also important to analyze your financial metrics in contrast to industry peers utilizing real-time data from private and publicly held companies.

Financial modeling is a key way to understand the current state of your business and where it is headed, even during times of uncertainty.

What Is Financial Modeling?
Financial modeling is building a proforma financial that can be manipulated to make business decisions. Financial modeling allows you to perform what if or sensitivity analysis, which can help you understand short-term and long-term impacts of potential scenarios.

Examples include:

• If revenue is reduced by 25% for the next three months, and accounts receivable turns go down five days, how much do I need to reduce overhead to maintain adequate cash flow for the next six months?
• If I hire a position at a certain dollar threshold, how much will that improve my inventory turnover and increase cash flow? Should I consider outsourcing assistance in financial or operational departments?

What Items Should I Consider in Terms of Financial Modeling?
Cash Flow
Generally speaking, increasing cash flow involves either increasing revenue, decreasing expense, or improving asset management.

Increasing revenue may be a real challenge right now. Companies may shift from growth mode to contraction and expense reduction. Many may analyze the income statement expense accounts line by line and focus on variable expenses, including:

• Negotiating with key vendors on direct materials
• Analyzing labor costs
• Commissions
• Freight
• Credit card fees

Fixed Costs
If your industry or business changes significantly, fixed costs will also need to be analyzed.

• Occupancy costs, especially if remote work arrangements are used
• Equipment and production capacity
• Admin costs
• Insurance
• Utilities

Asset Management
Don’t forget the impact that asset management has on cash flows. Think about improving the cash cycle from when money goes out of the business to when it comes back in.

• Increase turnover on accounts receivable
• Increase turnover of inventory
• Decrease turnover on accounts payable, but pay attention to early pay discounts

How to Begin Financial Modeling
You first need good historical financial information. From there, you can build out a spreadsheet that assess various components you’re hoping to track, like historical margins, growth rates and so. These scenarios will allow you to make assumptions and forecast future financial results.

It is important to build a model that allows you to make changes easily and track what results you get from these changes. A good financial model should be simple and easy to use. By using a well-structured layout, it will help you make more sense of the data you’re looking at.

While you can do financial modeling yourself, it also an option to have a trusted business advisor do it for you. They will have much of your historical financial information already and can further help you understand the various impacts of scenarios on your business.

Specifically, they can:

• Perform ratio and trend analysis
• Create a customized narrative report for easy to understand financial analysis
• Help understand your company’s value using an (informal) valuation tool
• Benchmark your key performance indicators (KPIs) against the industry

The Importance of Financial Modeling
In the wake of uncertainty with COVID-19, it’s important to know where your business is at and what impacts various factors may have in the long-run. This information will help you understand how future decisions will affect cash flow. Identifying areas of improvement and modeling “what-if” scenarios can help you make strategic, proactive decisions for your organization.