Business and Financial Models

Clive Marsh

• Publisher: Kogan Page
• Year: 2013
• Print ISBN:
  9780749468101
• Edition: 1
• eBook ISBN:
  9780749468279
• Topic: Business
• Subtopic: Finance
• Index: Business

A good business model should describe how an organization creates and delivers value, meaning that financial modelling is a vital tool for business strategy, allowing hypotheses and scenarios to be translated into numbers. It enables a company to experiment with different ideas and scenarios in a safe, low-risk environment, to consider what it is aiming to achieve, and to prioritize accordingly.
Business and Financial Models provides an accessible introduction to these essential strategic practices, with guidance on using Microsoft Excel for projection and analysis. The book takes you through the process of building your model from the initial phase of formulating questions through modelling cash flow, budgets, investment appraisal and 'dashboard' tools for monitoring performance.
Ideal for both small and large companies, Business and Financial Models also includes coverage of new visual thinking techniques, like Structured Visual Thinking, and how these can be incorporated into conventional business modelling.

Online supporting resources for this book include downloadable figures from the book.

CHAPTER ONE

STAGES IN THE DEVELOPMENT OF A BUSINESS AND FINANCIAL MODEL

Scope

A business model can cover the entire business or just a small part of it. Models are used for whole economies or just single business processes. They help define strategy and drive value.

FIGURE 1.1 Defining the scope of a model within the hierarchy of models is a key first step

Defining the scope will help determine the fundamental question to be answered and the outputs required from the model.

In the case of an economic model the rate of inflation may be a required output whereas, in the case of a company model, inflation may simply be an item of input data.

This book on business and financial modelling is primarily concerned with modelling a company and its investment decisions. However, the techniques described can also be used and applied to other levels of modelling.

The fundamental question

Start by describing what it is that you want your model to tell you. Some examples of typical research questions are given below:

• What return will an investment provide under different business and economic environments?

• How will our existing business perform over the next five years?

• When is the right time to develop an oil field?

• What business should we be in?

• What is our future funding requirement and where should it come from?

• What is limiting our expansion?

• How sensitive are our profits to changes in oil prices?

• How do we manage risk and how can we diversify/spread uncertainty?

Note that these questions will typically ask what, how and when! They can be the final question or they might just be a subordinate question that requires an answer before the main question can be fully addressed. Once you have agreed your fundamental research question you can define the specific outputs that will answer it.

Think, what question would you like to address in your own organization? What specific outputs would you require?

Outputs

Outputs are what the model is required to produce to answer the basic question. The modeller must define these outputs at the outset. For example, in the case of a simple yes/no investment decision question the outputs may include the net present value, the return on capital employed, the internal rate of return, the pay back period and the discounted cash flow.

Inputs

Having defined the outputs it will now be necessary to define the inputs required to enter into the model to produce the outputs. This is the data that is required to feed the model in order to generate output and answer the fundamental question. A full definition of inputs may not be possible at the outset particularly in the case of a large model. Input recognition may occur during the operation and further development of the model. Typical inputs may include:

• Resources required. These will include:

– Materials

– Human assets

– Overheads

– Energy

– Capital assets

– Funding

• Skills, innovation and development

• Costings

• Customer information including:

– Segmentation

– Price sensitivity

– Demand

– Channels

• Competitor information including:

– Barriers to entry

– New entrants

– Niche players

– Market shares

– Competitor supply costs

– Competitor vulnerability

• Socio/economic factors

• Political factors including taxation

• Legal and regulatory

• Other variables including:

– Inflation

– Wage rates

– Commodity and energy prices.

Defining limits to the scope of outputs and inputs can be difficult. Just how deep should you go? For example, would you just input inflation rates or would you input the variable factors that affect inflation rates? Define what you are modelling clearly. In summary, define your basic research question and output requirements first then research and obtain your input data required for your model.

The basic process is illustrated in the chart below:

FIGURE 1.2 Input – model – output

A step-by-step approach

There are no hard and fast rules governing the process of business model development. The chart outlined below is a guide and shows steps that may be taken and the information required.

FIGURE 1.3 Steps in model building

There are two initial stages in the modelling approach we shall use – thinking and evaluation.

Thinking

Thinking is all about making sure we are doing the right thing, or, ensuring that we don’t do the wrong thing really well. To assist us with our thinking we can use visual techniques – in Chapter 3 Group Partners consultants explain how this critical stage works in practice. Since most strategic thinking is performed by a group (an executive team) this is best carried out in a workshop where ideas can be captured visually and where dialogue can be put into context. This will require a facilitator who is skilled in visual thinking and contextual analysis. Often the facilitator will be an external consultant, particularly if the organization is looking for new direction and is facing fresh challenges.

Our initial thinking process should reveal what we are trying to achieve and the measurable outputs. It will define the inputs and resources needed to achieve the required outputs and all of the variable factors that will affect outcomes. During this stage scenarios will be identified.

In the same way that we need structure to traditional business plans and processes we will also benefit from structure to our thinking processes. Thinking is key to all business and a structure to this process can enable more valuable thoughts to materialize and be captured.

Evaluation

The evaluation stage is concerned with understanding the financial consequences of following certain courses of action. This will include income, costs, capital expenditure, funding and evaluating alternative investment options. It will involve the building of a business model, scenario and sensitivity analysis. The evaluation stage should conclude with a decision.

Although I have shown the above steps in a logical sequence it is in fact an iterative process.

Skills required

You can, of course, prepare your own business model and this book is intended to enable you to do just that. Complexity is not necessary and is, in fact, dangerous. For example, some models become the playthings o...

Table of contents

• Cover
• Title page
• Imprint
• Table of contents
• Acknowledgement
• Introduction
• 1. Stages in the development of a business and financial model
• 2. Developing the research question and output definition
• 3. Visual thinking to develop fundamental questions
• 4. Input definition
• 5. Scenario identification
• 6. Building a simple model
• 7. Using charts
• 8. Modelling budgets
• 9. Sales budgets
• 10. Production – material, labour and direct overhead budgets
• 11. Fixed assets and depreciation
• 12. Managing and modelling cash flow and working capital
• 13. Investment appraisal models
• 14. The cost of capitall
• 15. Business valuation models
• 16. Performance indicators
• 17. Modelling the company balance sheet, P&L and ratio analysis
• 18. Financial functions
• 19. Building a business model
• 20. Modelling projects
• 21. Integration, complexity and business models
• 22. Business models for the green economy
• Appendix 1: Excel shortcut commands
• Appendix 2: Chart for business model build project
• Appendix 3: Discounted cash flow tables
• Index
• Full imprint