Financial Models 101

All models are wrong, but some are useful.

This phrase was coined by George E.P. Box when referencing the nature of models as approximations. 

When we talk about models we have to inevitably think of desktop software like Microsoft Excel and Google Sheets. Models are sophisticated algorithms that can capture multiple inputs in order to determine their effect on an output. The quality of the output will be determined by the quality of the inputs.

Which inputs and outputs? 

Let's assume the output is a company's runway, i.e., the amount of months of cash available to keep operating.

If the company is looking for new hires (inputs), a model can easily show how the runway will change (output). If the company hires more staff it will affect the money it spends on a monthly basis (i.e., salaries).

The same analysis can be made for capital expenditures (also known as CAPEX). If a company is evaluating a large equipment purchase, a model can capture the cost and immediately show how the purchase will reduce runway.

Now, the analysis does not end there. 

The new hires could be a sales team. With more people selling, the company could increase revenues, which will be offset by the new hire's salaries. At this point, the analysis will focus on the incremental cash flow. If a new hire costs $5,000 per month and they bring $50,000 in revenue per month, it's an easier decision to make, as the incremental cash flow is positive, and it extends the runway.

Likewise, the purchasing of equipment might improve productivity and yield bigger profits, which would translate into a net positive cash flow when compared to the equipment's cost over time.

In that sense, financial models are meant to be scenario analysis powerhouses. 

If you have difficulty making financial decision due to not having a financial model or having one that is difficult to manage, feel free to reach out to us at contact@summa.consulting to find ways we can help you.