Financial modeling is crucial for businesses, especially when circumstances change.
The COVID-19 pandemic has left a lasting impact on the economy with businesses and governments facing uncertain times. This new normal has emphasized the importance of building business resilience. However, this can only happen if companies put in place measures which enable the handling of disruption.
One way to handle disruption is by forecasting the likelihood of occurrence of different unprecedented events and their impact on the operations of the business. This enables the firm to budget and plan for the future.
Financial models happen to be the best tools to help with the abstract representation of varying financial situations. Here’s how.
Run Multiple Scenarios Through While Financial Modeling
One of the most important steps you can take in financial modeling is scenario modeling. It requires evaluating or examining your model using different possible scenarios. This helps you to predict possible outcomes or a variety of possible results.
How does this help your business stand in uncertain times? Viewing your financial model through various scenarios allows you to forecast the different directions of cash flow. As such, you can predict what will happen during favorable and uncertain periods. This way, you can tell the positive and negative effects of such periods on your company’s finances.
When creating scenarios, it is essential to be as robust as possible. At a minimum, you should have the following three basic scenarios in your financial model:
Base scenario
This scenario is usually one that the business has experienced if it is an existing business. In this case, most companies make use of a “repeat of last year.” It means that you will consider your discount rates, tax rates and the growth rate of your cash flow. You can now make your predictions based on this scenario.
Best case scenario
In this case, you review the ideal scenario for your business. For example, you account for sales growth of up a realistic percentage, maybe 10%. This will be the highest possible growth rate or the lowest possible discount rate and tax rate. These conditions predict the best financial spell for a business to achieve its desired objectives.
Worst case scenario
This is where the most negative outcomes occur. In this case, you can calculate the net present value by considering the highest possible discount rate. After doing this, you can subtract the least growth rate of cash flow or the highest possible tax rate.
All three scenarios give you a clear picture of how your business will perform under different financial situations. As such, you can prepare for uncertain times.
Bring in Other Areas
Uncertain times result in a disruption of business activities. What this means is that the different departments of the business will suffer. For example, when the market is facing a downturn, then production reduces. This results in a chain of events that will gradually ground the other departments of the business.
Another example is COVID-19 lockdown. Because of the lockdown, businesses experienced an economic downturn which affected every aspect of their operation. It is essential to build a financial model that will help the company to survive such turbulent times.
You cannot successfully build such a model without taking forecasts from the different departments of the business. This is where “bringing in other areas” comes in handy. A lot of cross-sectional collaboration is necessary to review business metrics and data in real-time. With input from the different departments, your business can develop the right financial model to withstand uncertainty.
A simple example will be the collaboration between the sales and finance departments of a business. Both will work together to forecast the growth and cash flow of the company. In the end, you can find out what is vital to every department and make appropriate provisions ahead of time.
Play Out Your Scenarios
So far, you have different scenarios that your business will likely face. You may have also worked with the various departments in your startup to make forecasts. The next step is to simulate how your business would react to different scenarios.
For example, if you had a drop in sales by 10%, what effects will this have on your finances? How will you deal with this drop in sales to see that your business doesn’t suffer loss?
To do this, you must determine the following:
- Immediate action
- Mid-term action
- Long-term action
This is why your financial plan must have all these different plans in view. Make sure that you don’t just discuss these plans or lines of action. They shouldn’t only remain in your head. Ensure that you write them down on paper. It is easier to refer to these action plans when they are written down.
Figure Out The Best Way To Thrive
For many businesses, this is a continuation of “playing out your business scenarios.” In this case, you try to find out how best your business will survive uncertain times.
For example, if the problem is low sales, you must find out who else you can sell to. It would help if you also determined what other channels you can employ to sell your products. In a nutshell, you are trying to figure out different ways to generate revenue for your business.
It is imperative that you know your value proposition and find ways to communicate this to your target market. You also need to tweak your product to suit the ever-evolving needs of your target market. This way, your business will stay relevant even in uncertain times.
Use an Accounting Service Who Understands Volatility
One of the significant challenges that come with uncertain times is volatility. It is good that you have passed your financial model through multiple scenarios and brought several departments to evaluate it. Yet, you need to employ the services of a professional accounting service like Founder’s CPA that understands volatility.
We have an understanding of the metrics that you must review while building your financial model.
