Small businesses must capitalize on the huge benefits that financial modeling provide if they expect to move up to the next level. The problem is that many entrepreneurs equate “financial modeling” with the financial analysis of their business that’s attached to their five-year plan.
This is not exactly wrong, but we’re talking about more extensive modeling practices here. When done correctly, financial modeling is much more extensive and provides vision moving forward.
Poor cash flow management is the reason 82% of small businesses fail.
Why Utilize Financial Modeling?
Why should a small business use a full financial model rather than basing their decisions on the financial statement attached to their business plan? This answer might be different for each business, but it will almost always fall under one of these four categories:
- Cash flow management.
- Financial risk and strategy
- Quality of earnings
- Examining EBITDA
With that in mind, here are some benefits of financial modeling for small businesses.
A solid financial model can give your business an advantage over other small businesses that rely solely on their projections. Furthermore, it improves your reputation in the industry because not every business uses financial modeling.
You’re going to look much more professional to investors and force others in the industry to step up their game. It gives your business a significant competitive advantage. Another huge benefit is that a sound financial model provides small businesses with a sustainable plan for growth.
Sure, a company can survive by just breaking even every month but that type of plan would force them to become dependent debt financing to expand or adapt to changes in the market. Building a financial model shows you exactly where you can grow your business, presenting you with opportunities that cannot be seen with the naked eye.
That is what ultimately creates a financially stable business. It’s important that businesses be prepared to weather economic storms. Poor financial management is one of the top reasons why businesses fail so it’s important that you create financial stability.
Of course, having access to investors is a huge benefit to small businesses. People are much more open to investing money when a business has a financial model to show them.
This will answer a lot of questions for you, again giving you an advantage over your competition. Who do you think an investor is more likely to choose – a business that tells them their financial plans or a business that can show them their financial plans?
A Great Example
Let’s look at venture capital and private equity firms. Their main question is this:
What’s the Return on Investment?
They require a business to go through a rigorous budgeting process, which happens to encompass financial modeling. They want to see exactly where businesses need money, whether it’s marketing or product development. Maybe a business could just cut costs to boost their profitability?
The point here is that if a small business were to actually approach the firm with their financial model, then the entire process would go much more smoothly. Furthermore, it proves just how essential these models are to making proper decisions.
The Bottom Line
Financial models must be flexible and updated regularly. Forecasting should be part of your standard operations. You need the ability to pull real-time data from financial information in order to monitor the rapid changes that occur in the marketplace.
Models always use an analysis of actual results against forecasts to forecast cash flow. At the end of the day, financial modeling is used to determine the future profitability of a business, its position, and potential financial risks.
Jacob Haney is a content marketer presently working with Research Optimus, a business research outsourcing company. A writer by day and a reader by night, he is loathed to discuss himself in the third person but can be persuaded to do so from time to time.