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Do Your Own Business Modeling
by Joe Verderber
What is a "Business Model"? To me it is a financial representation of a business, created in such a way as to show what would be the results from the business (its outputs) if certain conditions of the business (its inputs) were changed. Raw material for construction of a business model is a computer spreadsheet program that makes it easy to relate variables to each other, and convenient to change the inputs.
In addition to the spreadsheet program as financial "modeling clay", there are some off-the-shelf patterns to show how the model should look. Those templates are the three basic financial statements for a business: the Income Statement, the Balance Sheet, and the Cash Flow Statement. Not every model need use all three of those templates. Some modeling questions can be handled with the use of the income statement alone. But, cash is the lifeblood of a business. Business models for questions such as distribution channel changes, product introductions, or business expansion are made more valuable and credible through consideration of the balance sheet changes and cash flows involved. The good news is that it is very easy to create a model that includes the balance sheet and cash flow statement. You don't need to have an accountant do it for you. You can do it yourself.
Developing The Business Model
The secret to making a good business model as the same as the key to making a good likeness of an object out of modeling clay. Namely, you have to decide in advance what it is that you are trying to model. What's the question you're trying to answer? What's the hypothesis you're trying to test? If you can state the question, you can set up a model to give you insights into the outputs of the business under the conditions you'll specify. Once you are clear about what the question is, you can structure your model to make it easy to see the answers. For example, if you are interested in the performance of your business over a number of years, you would not model just one year and use that model over and over again to simulate what would happen in successive years. Rather, you would create a model using multiple years, and define the basis of year-to-year changes, like wage escalation and cost inflation and even COGS reductions due to "learning curve" experience. This is easy to do yourself, with only limited knowledge of spreadsheet program use.
Equally importantly, you can set up the model to make it easy to change the input parameters and your assumptions about conditions in the model. In doing forecasting or modeling of the future, there is one thing of which you can be virtually certain. That is that your forecast is wrong. A good model makes it easy for you to change your forecast and assumptions by small or even large amounts and see in moments the impact on your business. You can readily determine sensitivity of your results to changes in your inputs or operating assumptions. When you learn which factors, or combinations of factors make the most adverse changes to the results, you'll be well on your way to managing your risks. For example, you may find that changes in the day's sales outstanding (DSO) of your customers' payables to you have a greater impact on your need for extra financing than do changes in your product cost of goods.
No matter how skillfully you construct it though, it is not the model itself, but rather your use of it, that will give you the insights you seek. Harold Geneen, long-time head of ITT and a renowned professional manager counseled his executives to "get behind the numbers". He felt that a successful manager had to work with the financial statements often enough and in sufficient detail that he or she could tell much of what was really going on in the business when the statements changed. Geneen made that statement in the days before there were commonly available spreadsheet programs. Use of a good spreadsheet business model gives a person a powerful opportunity to see the impacts of various combinations of input variables and assumptions not only on profit, but also on other important factors and ration. For example, you can readily model asset buildup or return on equity or the like. This becomes a powerful tool for employee goal-setting. For example, it is not practical to give a set of employees a performance goal to do something as broad as increase return on equity. On the other hand, it is perfectly appropriate to give a set of employees, such as sales people, service technicians, and even accounts receivable administrators the joint objective of reduction in the number of days' sales outstanding for receivables. Or, give materials management, production planning, marketing, sales and engineering personnel the objective of increasing inventory turns. A good model would help you demonstrate the value of such actions. You can even determine their cash value and earnings impacts on the Company. That in turn could help you justify and size some incentive compensation to propose for the achievement of those objectives.
Integrating Elements of the Model
You need not be an accountant to create a good, useable business model. You can build the skeleton of your model in a short time (hours, not days) by using one of the common spreadsheet programs. Create an income statement for your business. Follow it with a balance sheet. Follow that with a cash flow statement, and then tie the three together. For example, use of cash for an investment in capital equipment creates an entry into Property, Plant and Equipment assets on the balance sheet, and that in turn leads to a depreciation charge on the income statement. With just a little refresher on the essential principles of accounting, you can create the model even if you could not actually keep the books. There are a number of books and training courses available which will give you the basic understanding of accounting (or refresh it) in as little as a couple of hours. Take advantage of one if you don't feel comfortable with the financial statements, and then go create and use your model. "Get behind the numbers" and profit from it!
Think big! Think broadly. Create a spreadsheet model of your business, linking income statement with the balance sheet and cash flows. You'll be amazed at the insights use of it will give you.
Economical, On-Demand Course: Business Modeling
Check out our Business Modeling, On-Demand course which contains further information on this subject AND a fully functional Excel template to evaluate Usage-Based Pricing.
Boot Camp Half-Day Course: Business Modeling
An Outstanding Learning Opportunity
The course is designed to enable you as a non-accountant to build a usable financial model of a business. You'll use that model to determine and analyze proposed changes in the business, and to have a basis for selection among alternative strategies. You'll concentrate on the process and logic of modeling rather than on the numbers by which the model is expressed.
