Some entrepreneurs dread planning for the future, shirking the activity because no one can know what’s going to happen in the future. True, it’s hard to know what the future holds for each business, but the future is not actually the point of engaging in long-range planning. The value comes from what you learn during the planning process.
As Dr. Graeme Edwards put it, “It's not the plan that is important, it's the planning.” One of the most important tools an entrepreneur or CEO can use to plan is a five-year financial model. Consider the following six specific ways building a financial model will actually add immediate value to everything you are trying to accomplish.
1. Forces you to make assumptions about key performance drivers. Building a financial model will be an exercise in discovery about all of the moving parts in your company. Ask yourself:
- Which parts of your business are correlated, and which are not?
- Which costs are fixed, and which are variable?
- How do your accounts receivable grow in relation to your overall sales growth?
- How much inventory do you need to meet demand?
- How many leads do you need to make one sale?
- What is the average order size per customer?
- Can you increase your prices in the future?
- How much are you really going to grow?
- How many free versions can you give away before you go bankrupt?
All of these assumptions will start to teach you things you need to know about your enterprise.
2. Validates your correct assumptions. Once you’ve made all of these assumptions, you need to track your actual performance against them. It is so important to pay attention to the assumptions that you validate in this process. You can continue to make these assumptions confidently, which will quickly translate into greater accuracy in your short and long-range planning.
3. Brings accountability for and improvements to invalid assumptions. Without exception some of your assumptions will be wrong. Don’t be discouraged or disappointed when this occurs—expect it. Even the pros invalidate assumptions all the time. The key is to understand why you were wrong, and then make a better, more educated guess in your financial model for the future. Even if you have to endure multiple iterations, improving your assumption each time, you will gain more confidence in the future and learn more about your business and industry than most with whom you compete.
4. Empowers you with understanding of your entire business model. Yes, knowledge of what really makes your business successful—meaning more repeatable, scalable, profitable and cash-flow rich—is one of the major benefits you’ll receive from modeling your operations. One business I know used to have no clue what their actual gross margin was, yet they created many estimates per day that made assumptions about how they should price their products and services. Modeling is very powerful in connecting how each department and division benefits the whole, which inherently improves the entire business.
5. Improves decision-making. Vigilance in regularly reviewing your actual to assumed performance is the fuel that drives your ability to make changes in your business that you know will make a difference for the better. With all of this information about what’s driving your business, you’ll find that you quickly gain more clarity in making both short and long-term decisions. You’ll have quantitative data to back you up.
6. Gives you a baseline valuation. As you consistently improve the assumptions you make in your financial model, your picture of the future will become clearer. This clarity is very powerful, especially if someone makes a tempting offer to buy your company. Your five-year model is a powerful tool to determine the minimum price you might be willing to accept from a prospective acquirer of your company. If your five-year financial model says you’ll make a lot more money by running your business for the next five years than the offer they make, then you can confidently thank them but turn down their offer.
A financial model with validated assumptions makes the future very clear for the business owners and entrepreneurs who commit to creating it and keeping it updated with actual performance and improved assumptions. This clarity creates competitive advantages and improves the company’s chances for success.Ken Kaufman is the President & CFO of Aribex, an innovator of handheld devices disrupting medical imaging globally. As an award-winning executive with almost two decades of experience starting, growing, leading, and financing dozens of organizations, Ken is a highly sought-after speaker and author, including a best-seller, Impact Your Business.