It’s tough to know what tomorrow will bring for your business. Many businesses do their best to plan ahead, but it can be difficult to prepare for every scenario.
That’s where financial modeling and financial analysis come into play. Both are tools to help business owners and managers anticipate the impact of their choices – or of external events out of their control – on their company’s future performance.
While the terms might sound intimidating, fear not. Financial modeling is simply about imagining the effects of a change to the business, while financial analysis boils down to studying the business’ historical financial data to find opportunities for improvement.
A restaurant owner might model the financial implications of opening a second location, for example, while house painters might analyze their busiest months to determine when to hire more workers.
What Is Financial Modeling?
Financial models are fluid, financial snapshots built around the specifications a business wants to study. They can be built with complex software or even a simple spreadsheet. Either way, financial modeling demonstrates how a change in some variables – meaning potential scenarios or “assumptions” – will impact the business as a whole.
Financial models answer questions like, “If labor costs increased by 10%, how would my profitability change?” or, “What would be the impact of a 5% marginal profit increase?”
They can also be used for external purposes, such as to show potential investors the impact of an influx of capital. Unlike a financial forecast, which represents the most likely performance outcome for the future, a financial model explores “what-if” scenarios, the outcomes of which are presented in a pro forma financial statement.
There are two primary types of financial models: top-down and bottom-up.
Top-down modeling is when you assume a topline value and work down to see how to achieve it. If, for example, you want to capture 10% market share, a top-down model lets you tweak assumptions, such as hiring three more salespeople or expanding to a new territory, to create that scenario.
Bottom-up modeling starts with individual assumptions and carries the impact up through the company. If you want to see how closing five more sales a month would affect your bottom line, a bottom-up model may be helpful.
Whether on staff or contracted, an effective analyst will scour many sources of information, including financial statements, sales data, in-house and external research, and company's accounting books, to thoroughly report on finances and make future recommendations.
What Is Financial Analysis?
Financial analysis focuses on different aspects of the business, such as efficiency, productivity, profitability, and risk.
Small business financial analysts primarily work on future-planning and long-term goals, like five- or 10-year financial plans, rather than routine accounting work. They analyze a firm’s finances – such as the return on investment (ROI) from a marketing campaign or costly inefficiencies in a particular process – and provide recommendations to the CFO or controller via detailed reports with qualitative information and quantitative data.
In addition, analysts will often look at industrywide data and trends, as well as conduct competitive research, to present the business with a more objective look at its role in the market.
How to Create a Financial Model
All it takes is a simple spreadsheet to create your first financial model. With the right formulas, programs like Microsoft Excel, Google Sheets, or Apple Numbers can automatically calculate revenue, profit, operating expenses, and other financial values that may change depending on each assumption. Even a simple model can show how small changes ripple throughout a business’ finances.
One of the most important financial models is the “three-statement model,” which shows how assumptions will impact a company’s income statement, balance sheet, and cash flow statement.
Most modeling starts with the income statement, also referred to as the profit and loss (or P&L) statement, and uses pro forma revenue as the anchor for which all other assumptions are based.
For example, if a business creates a financial model to show revenue increases through higher sales, the model should answer questions like, “How will labor costs change?” that accompany an increase in its sales team’s size or hours worked.
Other common types of financial models:
- Merger model. Assesses the impact of a merger or acquisition of the buying company’s expected future earnings per share.
- Consolidation model. Maps out potential scenarios for consolidating multiple business units into one.
- Initial public offering. Helps a business analyze investor offers and expected stock prices.
- Strategic planning model. Helps financial planners create and adjust long-term strategic plans.
- Start-up model. Demonstrates the impact of early business decisions, such as leasing a building or hiring a team of employees.
How to Create a Financial Analysis
Before you assign a financial analysis project, you must first pinpoint what you want to analyze. Many analysts focus on examining a business’ financial status relative to its industry, competitors, budget, or forecast. Whether on staff or contracted, an effective analyst will scour many sources of information to thoroughly report on a company’s finances and make future recommendations.
Financial-Modeling Scenarios
Financial modeling is typically performed to inform decision-making about various business scenarios. Models are often based on the company’s historical financial data, such as revenue for the most recent quarter, and one or a set of assumptions it wants to evaluate.
Among the questions financial modeling can help answer:
- What if we launched a new product? Modeling a new product launch from historical or industrywide data can help a business assess important sales figures, such as the break-even point or how much revenue needs to be generated for various sales benchmarks.
- How would a new union contract affect our bottom line? If your business is negotiating a new labor contract, a financial model can demonstrate how various increases in wages or benefits may affect your margins.
- What if we opened a second location? Before expanding, modeling can simulate the financial impact of additional labor, inventory, and operating costs, to name a few, that accompany adding a new location.
For small businesses, most types of financial modeling can be handled internally. But for larger or less common situations, third-party consultants – such as an investment banker, lawyer, or accountant – can be brought in to handle the heavy-lifting.
Financial Analysis Scenarios
A financial model may provide the raw data for potential scenarios, but financial analysis turns that data into workable benchmarks to evaluate success, such as whether those new hires were worth the increased labor costs. Financial analysis methods may also uncover ways to increase productivity without expanding the workforce by eliminating redundancies or finding cost-saving measures.
Once a financial decision is made, results need to be monitored. This is often conducted through variance analysis, which compares projected results to actual results.
Let’s take a restaurant that modeled a revenue increase by adding outdoor dining. The model was predicated on 10 additional tables that would generate an additional monthly revenue of $50,000. However, after building the patio, only nine tables comfortably fit, so revenue was lower than expected. Variance analysis can be used to update forecasts and inform next year’s budget.
The Bottom Line
Financial modeling and financial analysis are two important arrows in a business’ toolkit to plan for growth. Many businesses create effective financial models using basic spreadsheet software to imagine the impact of a business change, such as launching a new product line. Analysis involves pouring through historical, market, and competitive data, among other sources, to reveal opportunities for improvement. Together they provide insight into how a business’ different decisions may play out.
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