Great entrepreneurs make great decisions by using all the information and tools at their disposal to make educated guesses in extreme uncertainty. One of the most powerful tools, financial modelling, can help you understand the financial implications of your decisions, the assumptions on which your business performance hinges, and the risks you need to mitigate to win.
What is Financial Modelling?
My first "employee" job was with my best friend’s Dad’s construction business at the height of the Celtic Tiger. One of my tasks was drafting quotes for work and he’d review what I’d done. “Jesus, Eoin, I can’t make any money off that!” he’d exclaim, when I underbid. He'd know what his cost base for any job was going to be, and calculated the margin and price appropriately to make sure he was accruing a profit.
Throughout my career, the best entrepreneurs and business people I’ve worked with use mathematics to help them make decisions and improve the performance of their companies. One of the most powerful ways to understand the financial implications of your decisions in a scaling startup is to build a financial model. Financial models are calculations that project the performance of a business (usually the P&L and simple cash positions, but sometimes including other financial statements and analyses) based on some key inputs, or assumptions, usually built in Microsoft Excel.
Financial Modelling as Analysis
A financial model does three important things:
Primarily, it will identify underlying assumptions in your business and the milestones on which your success hinges
Secondly, it helps identify the major risks to the business
Lastly, it helps describe the vision in financial terms – what the return you and your investors are will make
Those 3 purposes are in a deliberate order: most models describe your forecasted financial position, but from a strategic sense what you predict doesn’t actually matter. Great CEOs and investors use financial models to bring into focus what’s most important: the assumptions within your control that drive revenue and improve performance. It’s extremely unlikely a model will predict what will actually happen – but great CEOs and investors care deeply about thinking through the financial assumptions and risks.
Recently we helped a CEO think through how to calculate the commission rate for his sales team. One of the ways you can derive the commission rate is based on the revenue targets, but after talking that through with the CEO, he realised he hadn’t set specific, time-bound targets. While he had a sense of how many deals he wanted to sign in the next 12 months, he didn’t have a sense for how that might translate – or not – into the lead generation he should expect from his sales teams that week. Furthermore, he didn’t have a good understanding of how different levels of performance of the sales team would affect his overall financial position over time.
A well-constructed financial model can help you understand those dynamics so you can make informed practical decisions, like the target number of leads you’ll communicate to the sales team that week, or what the appropriate commission rate to pay them is.
Financial Modelling as Communication
While it’s important for the entrepreneur to understand how core assumptions will affect the potential upside and risks associated with a venture, financial modelling can also help you communicate the implications of your decisions and assumptions to others: potential investors, employees, banks, or boards. We recently worked with one of our clients to forecast how the financial performance of the business would change with introducing a new product line and revenue stream. It grounded the strategy discussion with the board in numbers, projections, and assumptions and gave them confidence the CEO had developed a coherent business strategy for accelerating revenue.
It’s important to note that financial modelling is just one way of using mathematics in business. Whole teams in companies are often deployed to serve as analysts, applying their brain-power to pursue better margins in a variety of contexts. Advanced computational methods combined with software are being deployed against a myriad of problems – what is often called things like data science, predictive modelling, machine learning, and artificial intelligence. Numerical fluency is a baseline expectation of today’s business leader - to compete in the future, we’ll all have to be able to model.
Eoin Hayes is the founder of Cantillon Labs, a consultancy dedicated to helping entrepreneurs scale their companies globally. He’s had over 7 years’ financial modelling experience for CEOs and CFOs from large companies and startups across 3 continents.