The Importance of a Financial Model
A while back, about a year ago, I was in discussions with a potential client company, and as part of the discussions I was reviewing the company’s financial model and business plan, or what it was attempting to pass as a business plan. The company was looking for expansion capital and senior management was frustrated with the results of their efforts. The company was roughly a dozen years old, and had recently undergone a change in management. The new management was very good from an operational standpoint. They had been able to dramatically improve the quality of their product and entered into new marketing agreements that resulted in new higher margin products being launched. However, they were operating with a very thin senior management staff, and lacked a true chief financial officer and really just had a bookkeeper in charge of the finance department.
The feedback that senior management was receiving was very positive, everyone liked the company, however they were unable to get any investor commitments. Upon review of what they had it became very obvious; their financial model was incomplete and did not properly differentiate between the two primary products. They had built their business off of a high volume, lower margin product and had recently introduced a higher end, high margin product that had the ability to surpass the lower margin product in sales.
The company was in the beverage business. The difference in the profit margins between the 2 products was very wide. The higher margin product had almost triple the profit margin of the low margin product. However the financial model was built upon total case sales of all products. It failed to separate the volume of the 2 different products. This caused a great deal of confusion and questions among potential investors. This caused a feeling of uncertainty where they never felt comfortable investing.
Another major flaw in the financial model is that it did not contain a balance sheet. This is one of the most important financial statements there is, and it was completely omitted from their financial model. Potential investors had no way of knowing how the balance sheet would need to be expanded in order to fuel the growth the company was expecting. More uncertainty, and no investor commitments.
A solid financial model will always accurately reflect the expenses items of a company, as well as the revenue of its products. Combining two products with vastly different profit margins is a major mistake. This is something that is not that hard to get right in the first place. Do it wrong can cause the financial projections to be significantly inaccurate. This could cause a company to show a loss when it should be expecting a profit.
Additionally a Cash Flow Statement and Balance Sheet a must have requirement for a solid financial model. The financial model should dynamically update so that as the various assumptions change, the whole model will automatically update. I know that there is a big tendency for most companies to leave these two (2) financial statements out of their models due to the complexity of producing them; but without them, the job of attracting needed capital become exponentially more difficult.
I’ve been in the meeting with the investment bankers who were deciding whether or not to issue a letter of intent to fund a company. I can tell you that a good business plan in important and gets their attention; but where the proverbial “rubber meets the road” and the decision to issue the letter of intent is made is in the scrutiny of the financial model. These investment banks are staffed by some extremely bright people who are experts at what they do and the industries they cover. They are going to subject your financial model to some extremely tough testing. Those companies with the financial models that withstand those tests are the ones who get the funding they are looking for. Those whose model’s don’t withstand those tests are left looking funding.
The beverage company did not really have a business plan either. It was attempting to use a power point presentation as its business plan. While the power point presentation was nice, it sorely lacked the detail of a good business plan. Management of the company seemed to understand the need for these things, but despite our best efforts we could never get the majority shareholder to agree. The last I heard, the company was still looking for funding over a year later.
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