Business vs. Financial Models

I’ve often seen the terms, “Business Model” and “Financial Model”, used interchangeably. In my mind, they are not the same but do need to make sense together. When I was finance support to product development, I distinguished between the “Big B” Business Plan from the b-plan financial model that I had built (in Excel) which spit out profit/loss, balance sheet, and cash flow statements to evaluate whether the project was a good idea from a financial “numbers” perspective. The “Business Model” is how an entity creates value for the customer by delivering a product or service (and gets paid for it). It is the full Business Story of a product/service idea. It includes a detailing of unique product/service benefits, go-to-market approach (how you reach the target customer) and how you will win vs. the competition. The “Financial Model” is how that win is monetized (sales/gross margin), sustained (operating expenses), and generates a return on investment (IRR/NPV) in a particular enterprise. They need to make sense together. Delivering value without a way to monetize it and financially sustain operations is not viable. A key link between the “Business Model” and “Financial Model” is the pricing approach. See an illustrative example below.

In my opinion, a strategic approach to pricing is often lacking. “Revenue Growth” at all costs (and the associated discounting, overspending on sales/marketing, etc.) ignores the fact that to sustain a business as an ongoing concern requires (eventually) operating profit and cash flow. Finally, the financial model needs to be embedded in specific business processes in a company so that everyday decisions and planning from pricing to budgets to the ongoing work of the financial planning and analysis group (FP&A). These activities must directly correlate to achieving an enterprise’s financial targets. You can’t “plan to win” without the winning recipe baked into key processes.

Business Model - “Big B” Business Plan

To get a sense of the business model or “Big B” Business Plan, I would read any product requirements documentation (PRD) that I could get my hands on. There were usually several paragraphs written describing the product/service purpose, target customer, place in the market, etc. There was also often an early rendering or diagram that gave me a picture to anchor all the other descriptive information. It is important to understand the big picture of the business model to apply the financial model in a way that gives the most realistic projection of how the idea will perform financially if/when it goes to market. Below are some examples of business models in various domains.

Financial Model – Target Financial Statement Ratios

The financial model is a numbers-based reflection of the business model that shows how product cost, pricing, marketing/distribution, and corporate expenses need to play out for the concept to be financially successful in “steady state.” Below is an example of a generic financial model for a product intended to be sold at retail (sell product B2B to a retailer) and direct-to-consumer (DTC) via ecommerce.

A quick financial model like this (in Excel) is a useful tool to gauge whether a business concept has a chance to be viable.

It is important to achieve revenue scale to evaluate a business against the target financial model, but it can’t take forever to reach scale. In my experience, the “my business just hasn’t reached scale yet to meet the financial model” plea only works for about 18 months or two high seasons (if highly seasonal). Businesses on their way to scale need to grow at a 75%+ annual rate. Businesses enjoying moderate growth (20%+) will never get enough leverage over growth-driven expense and working capital increases to be viable in “steady state.” Their “steady state” is a loss, drag on enterprise cash flow, and opportunity cost on better uses of company capital.

Key Business Processes Need to be Designed and Executed with Financial Model Outcomes in Mind

It was Benjamin Franklin who coined the phrase, “If you fail to plan, you plan to fail.” I would add to this that planning is not a path to success if you don’t follow it. A financial model needs to live inside of how key business processes are designed, executed, and governed. Enterprise-wide business processes such as product pricing and budgeting immediately come to mind, but also “niche” processes that govern inventory, tax, and capital appropriation must be tied to (and achieve) the assumptions that make the financial model work. In my experience, underperformance vs. the financial model often occurs because of a lack of discipline/adherence or a disconnect between the model and day-to-day processes that dictate outcomes. The table below shows some finance-related business processes that should be designed and executed with the financial model in mind.

If your financial model is the “big picture” representation of what economic success for your business looks like, then the design, execution, and governance of key business processes are the “little pictures” that will produce that successful outcome.

The terms “Business Model” and “Financial Model” are often used interchangeably. In my view, they are related, but not the same. The “Business Model” is the grand vision of how you are going to create value for a customer by uniquely satisfying a customer/market need and make money doing it. The “make money” part is where the “Financial Model” comes in. It is a numbers-based reflection of what is required from a profitability, balance sheet, and cash flow perspective to make the business viable on an ongoing, steady-state basis (at scale). In order to achieve the outcomes set out by any financial model, its targets and logic need to be built into key business planning and day-to-day operating processes. There are many industry-disrupting business models in the market today, but as far as I know, cash is still king and if a business model doesn’t have a viable financial model that allows it to monetize the value it creates, it won’t/can’t survive.