To be honest, I’ve debated about whether I should write about financial modeling. If you’re anything like my girlfriend Amy, the mere thought of financial modeling causes great anxiety and a profound desire to change the topic. And I’m pretty sure that a post on creating spreadsheet representations of your business may not go viral.

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But the simple truth is that financial models are incredibly powerful tools and they’re not that hard to create. Models are also required to do certain types of risk evaluation (as I talk about here, here and here..) In fact, models of the financial kind can be kind of sexy – at least to the engineering types like me.

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Well, now that I think about it the models really aren’t that sexy…did I mention that financial models are incredibly powerful?

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So what is a financial model?

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It’s a numerical representation of your business. It shows revenues, expenses and cash flow and all of their components. A model lists all of the assumptions (and there are a lot of them) with the assumed value for each. If you use formulas when you create the model, it’s possible to test different scenarios by changing the assumed values.

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Here’s a simple example. Fred owns a coffee shop. In his model, he calculates revenue by assuming the number of cups of coffee he will sell each month and multiplying that number by an average price per cup.

Sales = # of cups x $/cup

In this example there are two assumptions. That means there are two risks and two opportunities, right? The actual result for each assumption could turn out to be wrong in a negative way (a risk) or wrong in a positive way (an opportunity). By changing the assumed values, you can see the financial impact of risks and opportunities directly from the model.

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You can apply the same technique to the direct expenses, the overhead expenses and even cash flow factors like how quickly you pay your invoices and how quickly you get paid by your customers. I arrange the numbers in a column for each month. The end result looks very similar to an income statement (a.k.a. P&L report).

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I’ve done a lot of financial models in my time – for business planning, budgeting and forecasting. I continue to be amazed by the amount of information a good model will give you.

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I’m going to continue this series and give you some more detail on financial modeling over the coming weeks. I’ve also created a public sample financial model for Fred’s Coffee Shop. You can check it out here (I’m using Google documents since they are easy to share. I typically do my modeling in MS Excel). Feel free to make a copy and play with it. So far I’ve only created the income statement portion of the model, but I’ll be adding some cash flow components to it.

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Don’t hesitate to contact me with any questions. This type of modeling has become an area of expertise for me (in MS Excel spreadsheets) and I’m happy to help.

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Do you use any sort of financial modeling in your business? I’d love to hear about your experiences.

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