Using financial modeling to double your profits

A financial model is like a dashboard on an airplane or a map on a hike – your tool to replay various scenarios of your business development. An effective financial model will help you find new growth points and significantly increase profits.

What is a financial model and why does a business need one?

Financial modeling is a forecast of the company’s future financials. Whether you model the entire business or specific operations, the process helps you identify factors that will have impact on your profits in the future.

Depending on the goals and users of the specific financial model, you would want to include different inputs and assumptions into it:

for the investor, the emphasis would be on the return on investment and profitability;
for internal planning and forecasting development scenarios, financial modeling focuses on growth points and planning future periods;
for banks, the financial model should demonstrate the sufficiency of funds to cover all upcoming payments on your new loans.

One step at a time

Financial professionals often joke: “First we get rich in Excel, and then in reality.” To make sure that your reporting data is not detached from reality, you first need to understand the financial modeling process. Suppose a business faces an ambitious task – to double profits, and you want to use the financial modeling tool. What is the first step to take?

Analyzing and forecasting

Always start with baseline values and scenarios – think what will happen if your leave everything as it is.

The first step will be to take all the actual data from your income statement, cash flow statement, balance sheet, and other analytical reports – which will go as deep as the analytics you collect in your business – and simply project all the indicators to future periods, as if the pace of your growth or regression remains at the same level. If this forecast does not look particularly inspiring to you, move on to the next step.

Identifying growth points

Looking for growth points means trying to identify opportunities to increase revenue and net profit. If you already have an action plan, then it is best to calculate its impact on future periods using all the inputs that you have: the volume of supplies, the new average check, the new conversions that come from your marketing strategies, and so on.

If you have no ideas yet, this is the moment to generate them and draw up an action plan for their implementation, and then recalculate your financial model to include them. This means you change the inputs into your financial model and look how the improvements you plan will impact your financials.

Different events have different effects. If you want to double growth or more, you will need to identify the most effective improvements, those that will have a greater effect on your net profit.

For example, if you want your marketing department to bolster your conversion rate by 1%, your financial model can show you a subsequent revenue and net profit growth by a larger percentage, for example, by 5-10%. Finding a way to up the average check by 10%, you may see a greater effect, such as higher profitability of your business.

You can estimate which is more effective for your business, to lease a vehicle or use a transport company, or assess how a potential change in the employee motivation system will affect the financial situation. Which is more effective – higher salaries, a percentage of sales or profit margin added to their compensation package, or something else? Using a financial model, you can play out business development scenarios and model the outcomes of various hypotheses.

Understanding whether goals are achievable

Now, it’s crucial to assess the feasibility of your set goals and planned activities. A financial model can help calculate the resources required to achieve them. For instance, it can determine the cost of new staff, additional capacities, or the amount of borrowed funds needed to meet required supply volumes. All these factors must be calculated.

Preventing cash flow shortfalls

Cash flow should be planned to avoid shortfalls during the planned period. If you identify months with a negative balance, develop a plan to negotiate extended payment terms with suppliers, adjust the supply plan, or consider refinancing existing loans.

Financial models can be extensive and multi-option, but they allow you to track the correlation of business indicators. By changing a value in an Excel sheet at the sales funnel level, for example, you can see how it affects net profit over a period.

This kind of “what-if” analysis provides greater transparency into how factors like material costs, conversion rates, or website traffic impact profitability. You can then focus on the most impactful actions.

Two modeling methods

There are two main approaches to building a financial model. You can start from the top down by projecting sales volume, associated costs, and calculating net profit.

Alternatively, you can start from the bottom up by setting a desired net profit and working backward to determine the necessary sales volume, conversion rates, and other metrics.

Recommendations and tips

To ensure your calculations are realistic, follow these guidelines:

Create development scenarios but avoid overly pessimistic or optimistic forecasts that don’t align with market capacity. For example, in some financial models I have seen projected sales volumes that are not feasible for the product category in question; moreover, the market for this particular category is stagnant.
Align with company goals: if you only sell quality products, there is no need to make calculations for a cheaper segment and lower purchase amounts.
Use accurate input data to base your model on verified data, not estimates.
Regularly compare your actual results to your model’s projections to improve future planning. Otherwise your financial model will be merely a dead sheet and a calculation exercise. The plan to outcome analysis helps increase the accuracy of planning and stick to the target.

No truly successful business can exist without a financial model. It assesses growth prospects, identifies risks and opportunities. Most importantly, a working financial model accelerates the achievement of goals.