Thought Piece
Basing financial models on the business model
Too often investors don't fully understand what drives the business and only really gain that understanding when the financials have gone wrong, and sometimes that can be too late.
"Much of my time is spent producing financial planning, modelling and analysis; working with investors to ensure that they are basing their investment decision on the reality of what is happening in the business."
"People who work in the company know what drives performance, it is in the DNA of the business"
"Some fresh air and a clean piece of paper can be the best place to start the modelling process"
Across many sectors — including finance and utility where I have worked — investors too often base their view of likely results on optimistic projections which have little to do with the actual factors that drive business performance. But this doesn't need to be the case: it is possible for financial models to be based on and aligned to the business model.
Investors and those running businesses need to stop confusing business modelling with financial modelling. One problem is that the business model in many companies is not made explicit. People who work in the company know what drives performance, it is in the DNA of the business, but they often fail to see the need to communicate that to outside investors or believe it is so obvious that it needs no explanation.
Much of my time is spent producing financial planning, modelling and analysis; working with investors to ensure that they are basing their investment decisions on the reality of what is happening in the business.
At times I have been asked to work in situations where performance is failing to meet the target set out in the financial model. At that point investors — whether equity or debt — often realise they don't understand the business and that the model they are working with bears little relation to the commercial reality. So for example, if investors are presented with accounts that tell them that the revenue is below expectations, they have no detailed grasp of why that is the case. Investors need to understand what produces the revenues and costs; what impacts margins and what are likely to be the resulting cash flows.
We all know that when financial performance starts to go awry, investors become nervous. Stress levels are raised even further by the dawning realisation that they didn't understand the details of the business as well as they had initially believed. The good news is it is perfectly possible to produce plans and projections that meet the needs of investors and yet which pass the reality check of providing meaningful insight into how the business actually works.
Of course, it is important to plan and model for particular transactions such as a loan or an equity investment. But that planning has to be based on, and dovetail with, the business plans that look at what drives revenues, costs, profitability and cashflow.
While we all use technology these days from Excel onwards to help with our modelling and forecasting, a deep breath, some fresh air and a clean piece of paper can be the best place to start the modelling process. And once a proper modelling process is undertaken, in my experience business insights are often revealed, pointing to a good news story, replacing frowns with smiles on the faces of the investors.
This process of modelling benefits the company as well as the investors
This process of modelling benefits the company as well as the investors by ensuring that confidence in the management is not dissipated. Then management can retain control, working with investors who are prepared to stay the course.
Charlie Inego-Jones