Part 9 - Now, we do need numbers

Financial Modelling

Before we can go much further, we are going to have to answer some deep questions about raising finance for a business. Questions like:

• What is my business worth?
• What price should I sell shares at?
• Can I repay a loan, and if so, how fast?
• What will my business look like in 1,2, or 3 years’ time?
• What will this be worth to sell in future?
• What will the founders, investors and lenders earn from participating in this?
• What might change?

And, to answer those we need two things:

1. A set of reliable accounts for the history of the company in standard (and IFRS compliant)?
2. A financial model of the future?

Very few companies, and even fewer start-up and early growth companies really know how to make financial forecasts that help them manage their business, drive growth, and raise finance. The whole area of financial forecasting is probably two or three years of explanation, training, and exercises for a moderately competent accountant. But what we can hope to get over in this short article are some of the key features that any CEO or COO should ask for.

When it comes to financial modelling, most people only produce a simple profit and loss account on a cash basis. They work out what they will spend and what cash they will get in from sales each month and apply some simple growth assumptions to that model. I would urge anybody who is thinking of producing a financial model to work with somebody who has some accounting experience and who can prepare them a proper three-step model covering profit and loss, balance sheet, and cash flow. Taken together, all three elements give you a much better view of the way in which your business is likely to work. They also provide a much better basis for estimating the value of your company and the cost of investment.

A tidy model, with well thought out assumptions that are linked to solid evidence from independent sources, and which indicates the major drivers of value in your business is a good stepping stone towards a dialogue with the potential lender or investor. Wherever possible, the assumptions that you use should be external and activity driven, rather than just a simple “next month we will sell 20% more than last month”. Any investor or lender will have access to phenomenal large datasets of financial information from competitors in your sector, and they will very quickly identify where your model is not realistic unless you have done your homework properly.

The questions I always ask about a financial model are

1. Is it entirely driven by external factors?
2. Is it driven by activity levels?
3. Does it identify every step in the sales to cash chain with appropriate and controllable KPIs?
4. Are all assumptions clearly identified and reasonable against solid information?
5. What is the learning curve factor that you are using?
6. Are you 100% sure it has no hidden assumptions, constants or factors?
7. Are all ‘links’ and factors identified and shown clearly?
8. Is is capable of accepting any reasonable change to any assumption on a ‘Scenario Basis’?
9. Does it record all changes, so it is always possible to roll back to earlier versions safely?
10. Can it provide output in the same format as financial accounts to allow instant real time comparison?
11. Can it also output critical KPIs, and value indicators (margin percentages, EBITDA, etc)
12. Does the model integrate profit and loss, cash flow, and balance sheet correctly, after taking into account all known timing and taxation factors?
13. How does it compare to the reality of competitor companies in your sector?

Most of the time I’m very disappointed by the answers that I get. A great deal of the information that people attempt to use to manage their companies is placed into Excel spreadsheets, literally my least favourite way of producing a financial forecast, which are then randomly amended over a period of time. This is very sad, considering so many excellent forecasting tools exist that can be integrated with financial systems. Xero, Iris, Sage, Dynamics and many others have such forecasting systems.

Very few forecasts I’m shown past the first three tests. There is a habit of “starting with the expenses” when producing a forecast. This leads to consistent, but ultimately useless models which bake in current inefficiencies and bad working practices for the long-term future. Many in-house accountants are good at showing internal assumptions. Things like “each person uses five pencils a year”. But then they bake in and hide some of the bigger assumptions, things like productivity, efficiency, staff turnover rates, customer retention, and fixed overhead costs.

What are looking for in the model is something that shows that it is based on the outside world and clearly walks through from the total addressable market, through exposure, to conversion, to sale, to completion of an order, through retention, to the collection of cash.