Financial modelling can be described as a “what if” exercise. What if we set the price of our new product at $100 and sell 5,000 units? What will be the effect on our profits?
It’s all about simulating various scenarios while keeping a close eye on their impact on profitability and cash flow.
Admittedly, in some cases you will be picking numbers out of the air and guessing. Indeed, one of the dangers of modelling is that you may be tempted to forecast revenues too high and expenses too low.
That’s why the more real world information drawn from financial statements and market research you can plug in, the more accurate your forecasts will be. Also, working with a professional consultant can help you eliminate some of the subjectivity involved in simulating different scenarios and help you forecast more realistically.
Worth the effort
The exercise can get complicated, but the outcomes are worth it. For example, when planning to launch a new product, a manufacturer would consider the following factors in a financial modelling exercise:
- Required investment for material, human resources, equipment and premises
- Additional selling costs, such as transportation or marketing
- Number of units to be sold
- Price per unit
- Competitive prices in the market for the same type of product or services
- Size of the market
- Market conditions—Is it growing, declining or stagnating?
- Intensity of the competition
- Potential market share
- Estimated revenue
- Estimated profit
It’s a foregone conclusion that your financial model will differ from what actually happens as time passes and conditions change. And that’s why it’s critical to update your financial models and overall strategic plan on a regular basis.