Beyond M&A: 4 Other Types of Financial Models
When most people think of financial modelling, I’d wager that M&A (mergers & acquisitions) and valuations come to mind. And why shouldn’t they? These are situations where financial modelling is absolutely crucial, for both buyer and seller need to come up with a justifiable price that forecasts the operational and financial situation of the company in question.
But there are other types of financial models that add just as much value to an organization’s strategy and operations, and these are sometimes overshadowed in small- and medium-sized businesses’ CFOs’ and Controllers’ minds by M&A and valuation modelling. In my experience, without building and regularly using these types of other day-in-day-out models, growing organizations are leaving an awful lot of value that can be added on the table. So what are these other types of models?
Strategic Plan / Entire Company Models
Description: These are better called “Strategic Plan Models” for their function, but “Entire Company Model” is suitable for its descriptive value, because that’s what this type of model is. In essence, it breaks out and forecasts a company’s operations and finances to a high level of detail—enough that the moving parts can be well understood, without being too onerous to set up. Revenue and expense drivers (quantities, prices, costs per unit sold, head count to provide a certain amount of service, etc.) by product line, geography or business unit are each forecast individually. Along with these, other elements that comprise the current and future financial situation of the company are forecast—debt repayments, major capital expenditures, hiring growth, etc. Together, these items all flow through the three financial statements—balance sheet, cash flow statement, and income statement—in order to create a 360⁰ view of the business. Items that are calculated from these initial assumptions include working capital (receivables, inventory and payables), income tax payable, income tax expense, depreciation (both accounting and tax), growth metrics, and valuations.
Uses: This is the you-can’t-do-without-it model—because it does so much, it has that many different possible uses. Since revenue and expense drivers have to be forecast in such detail, this type of model is extremely helpful for variance analysis, and for forcing business leaders—finance and otherwise—to think strategically about the business (which products are most profitable, which aren’t, which divisions or locations are growing, etc.). The Strategic Plan Model is also useful for keeping an eye on the company’s cash position, and ensuring adequate funding not only for big-ticket capital purchases but also day-to-day growth in inventory and receivables as the business organically grows. It can even be used to get a very rough estimate of what the company’s tax bill will be for a future year. However the model is used internally, the fact that a small- or medium-sized business has one and updates it regularly is a strong plus for lenders and investors, and is something that can and should be shared when the right opportunity comes along.
Expansion Plant Models
Description: An Expansion Plant Model is similar to a Strategic Plan Model in that revenue and expense drivers are modelled, through to generating the three key financial statements. It differs, however, in that it focuses solely on the revenues and expenses associated with an expansion plant (a new factory, piece of equipment, store or location). In other words, it takes an incremental approach—only revenues and expenses that are additional to the firm because of the decision to undertake this expansion project are included. Incremental means other things, too: if the company has a lower and upper tax rate and would be paying the upper rate before the expansion project, only the upper rate should be modelled. And if the expansion project involves a new product that will cannibalize existing revenues from other products the company currently offers, then “negative” incremental revenue should be modelled. Typically, the cash flow profile for this type of model will involve a large negative cash flow at the beginning—the construction of the new plant—and then small but growing positive cash flows over time.
Uses: The Expansion Plant Model has two major uses. First, for internal decisionmakers like company owners, presidents and CFOs, the Expansion Plant Model allows the user to test how various assumptions (e.g., Base Case, Pessimistic and Optimistic sales scenarios) affect the viability of the project, to determine whether it truly makes sense to proceed before investing significant amounts of capital. Secondly, external decisionmakers like lenders and investors can use the model to do their own due diligence on the project in reaching a decision on whether to finance it. In my discussions with lenders, a solid Expansion Plant Model, especially one created by a neutral third party, can go a long way in securing financing at a competitive rate.
Specific Bid / RFP Models
Description: A Specific Bid Model is a model that is constructed for a single bid / deal, or to respond for a request for proposal. Like an Expansion Plant Model, it takes an incremental approach, focusing only on those cash flows that are related to this bid; like the Strategic Plan Model and the Expansion Plant Model, both revenue and expense drivers are forecast. In many instances where we’ve built this type of model, we’ve seen notable upfront expenses (capital expenditures or operating expenses), and then revenues occurring regularly for several years out, along with corresponding variable costs or COGS. Often this is complicated further still by a mix of different products and services, each with their own timing. The upshot is that responding to complex bids shouldn’t be done without building this type of model—it’s just too easy to miss something, and thus to lose the bid (or worse, win it but still lose money).
Uses: The goal of building a Specific Bid Model is to win the bid, and to win it profitably. This always involves a trade-off between pricing low enough to get the business while pricing high enough to generate a decent return, and the Specific Bid Model is the keystone in making these decisions internally. Often, key outputs—such as specific service or specific location pricing—will be extracted from the Specific Bid Model and dropped directly into the RFP document, without the associated internal costs and profitability analysis, of course. The Specific Bid Model can also be tied into the Strategic Plan Model, and realistically should be if the bid represents a significant portion of the company’s revenues, as this will allow the company to budget for the expenditures—hiring, purchasing equipment, etc.—necessary to satisfy both this bid and the rest of the company’s business.
Description: A Cost Model takes many cues from the other types of models, but it also has a number of differences. While it’s still incremental, like the Specific Bid and Expansion Plant Models, it omits the key revenue piece in its entirety. Instead, it focuses on determining the cost of providing a single additional unit of service or product by summing up all the different fixed and variable costs and dividing them by the number of units provided. Often, this can be tricky, because a number of “cost centres”—like rent for factory premises—touch on a variety of different types of services and products. Moreover, the Cost Model requires the user to make assumptions about the volume of service or product that will be provided over, say, the next year—after all, producing 1 widget per year will often have almost the same fixed costs as producing 1,000, or 100,000. Because of this sensitivity to the volume assumption, a tie-in with the Strategic Plan Model’s sales volumes forecasts can be helpful.
Uses: A Cost Model is used for determining the profitability of a product or service line. Often, that means this type of model will feed into the Strategic Plan Model so that executives can understand what’s working for the company and what’s not, and how that stands to change if one product takes off relative to another. By integrating the Cost Model in this way, internal decisionmakers can take a hard look at the company’s strategy and make tough decisions like discontinuing one product and heavily promoting another. Furthermore, Cost Models’ outputs are often useful inputs for Specific Bid Models, allowing the company to set pricing at a level that will win the bid while not eating into margins. In some instances, the Cost Model will show how the company can bid low on a new long-shot project so long as its bread-and-butter business stays intact, owing to economies of scale. Through this type of use, a Cost Model is a critical support to winning bids and allowing the company to flourish.
There are, of course, many other types of financial models, but these are some of the major categories. Whatever the model, they are useful tools that allow decisions to be based more on quantitative fact and less on emotion. That said, it’s important to remember that they’re just tools, and at the end of the day, even the best model will still require a level of judgment to be used properly. When wedded with strategic experience, though, a model is a potent implement and one that can support great business success.