3 Things a Good Financial Model Can Tell You
My CFO would kill me for saying this, but I usually describe financial modeling as “the circle that tells you what to spend in different areas.”
“Pie chart” is a more technical term, but the description is accurate. The financial model tells you how to allocate resources inside your company—and how much should be left over in profit when you’re done spending.
You can break down your financial modeling in different ways, but standard categories might include:
• Cost of goods/direct labor costs: the money you spend to make your product or deliver your service
• G&A (general and administrative): expenses for your leadership team and anyone else not considered direct labor; admin expenses like rent, office supplies, bank fees, etc.
• Sales and marketing: the activities you spend money on to get new clients or customers
• R&D (research and development): your budget for developing new products or trying new ideas (not just for product-based businesses; think about the innovation budget at a company like Google)
The result is something like this:
Nice, right?
Now, let’s get into the very important information you can actually learn from your financial model.
3 Things Financial Modeling Can Tell You
Once you set the percentages—and assuming you have regular financial reporting in your company—here’s what financial modeling can tell you:
1. If your business model works.
Low gross profit is one of the top secret killers of small businesses. Even high-growth startups that lose money every month still need a product that can be delivered with the right gross margins. If your COGS/direct labor costs are too high, your model is broken, and you need to fix it ASAP.
2. Where you’re spending too much.
Overspending might be the issue behind problem #1, but you can overspend in other areas, too. G&A is particularly suspect to overspending: companies easily get bloated with administrative employees and senior leaders who have expensive salaries.
You want to watch these expenses closely—overspending on G&A won’t break your model, but it has a major impact on your personal profit as the owner.
3. Where you aren’t spending enough.
Yes, there is such a thing as underspending. This is most common with a company’s sales and marketing spend. Sales and marketing are often undervalued by entrepreneurs. The ROI isn’t always as measurable as we’d like…and there are a lot of marketers out there who don’t deliver.
The problem is that your marketing engine (once you get it up and running) is the lifeblood of your business. You can’t sell your way out of every problem, but you can sell your way out of at least 80% of them.
Tips for Building a Financial Model
The foundation of your financial model is really just knowing what percentages to plug in for each area on the pie chart.
Industry benchmarking is a great place to start. If you have a CFO, they may know this info off the top of their head.
If you don’t have a CFO, turn to Google. Something like “average sales and marketing spend for consulting companies” will turn up more results than you expect. Or, reach out to us if you’re interested in working with a fractional CFO.
You can also talk to industry peers—assuming they know what they’re doing and that their companies make money. See how they allocate their resources and how closely their business structure maps to yours.
Financial modeling gives you valuable information about your company, and it also serves as a compass to let you know what direction you want to head in as you grow. Let us know if we can help you with yours.
