What is Financial Modeling and Why Should Your Small Business Use It?

Planning for the future of your small business is an important part of success. Financial modeling takes different shapes, but basically, ...

Planning for the future of your small business is an important part of success. Financial modeling takes different shapes, but basically, it’s about plugging different numbers and scenarios into a formula very often on an excel sheet and seeing the effect they have.

Financial Modeling in Action

Small Business Trends spoke with various business experts about this useful tool and how it works for small business.

Healy Jones from Kruze Consulting clarified how these tools can help a startup get rolling or an established business move forward when they are considering expansion.

Understanding Costs and Profits

“A well built financial model will help a business owner understand the costs and profits from their management decisions. What will it cost to open a new location, hire a new employee, and how does that impact the bottom line?” he says.

He went on to say that a good financial model can answer questions like whether your small business should buy a new piece of equipment or pay down debt too.

“These can even tell businesses they have enough customer service people to take on the number of customers they want to next year.”

Using Real World Starting Points

Although you can pick some numbers out of the air and plug them in (what happens if we price our widgets at $400 dollars and sell 6000?) more accurate results come with more real world starting points.

That’s why using financial statements and market research will give you more accurate results. It’s even a good idea to consider a professional consultant to get an objective base to start from.

Daniel Feiman from BuildItBackwards.com explains how to use base line once you’ve put one together.

Establishing Extreme Outcomes

“Frequently you want to establish the most extreme possible outcomes by modeling the best and worst case, then anything else that happens somewhere in between,” he says.

You can get a bunch of different scenarios by changing the variables which can be factors like the size of your target market, price per unit (which can even include extra selling costs like transportation) and estimated profit.

One of the best things about financial modeling is it’s always a work in progress. As time goes by and your small business conditions change, you’ll always have the ability to plug in new numbers to see what comes out.

As you might imagine, there are a variety of financial models to choose from. However, there are a few that are considered standards:

The Three Statement Model. This is one of the more basic ones that covers incomes statements, cash flow and balance sheets.
The Discounted Cash Flow Model. Don’t let the name scare you off. This model builds on the previous one to value a company.
The Budget Model. Like the name implies, this is the model that’s used to put a budget together.

Other models that small business should find helpful include a forecasting model and option pricing model that basically makes use of the calculator built into excel.

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This article, "What is Financial Modeling and Why Should Your Small Business Use It?" was first published on Small Business Trends