Importance of Financial Modelling

Little Johnny started a lemonade stall in summer break.

Assuming that the lemonade stall sold 15 lemonades on weekdays and 30 on weekends for 4 weeks accumulating sales of 360 lemonades for half an EUR each for cumulative sales of 180 EUR. Deducting the cost of goods including lime, sugar, salt and water of approximately 50 EUR, we can foresee gross profits of 130 EUR which sounds pretty lucrative for little Johnny.

Cost of Goods (CoG): 50 EUR (Lemons – 35 EUR; Sugar, Salt & Miscellaneous – 15 EUR)

Difference between the terms ‘gross’ and ‘net’ is where all the magic happens. Concluding based on gross profits is naïve. With increasing competition, margins are shrinking day-by-day and failure to optimise costs through financial modelling can lead to catastrophic failures and severe cash crunches.

Let us use this example of little Johnny’s lemonade stall to understand the magic.

To start any business one requires to acquire some capital assets to either create value or help facilitate delivery in case of services. In this case, to set up a lemonade stall Johnny acquired a wooden table and some fixtures from a yard sale along with two sets of glasses.

Capital Expense: 35 EUR (Glasses – 20 EUR + Table – 15 EUR)

After starting the stall with low turnout on the first few days, Johnny realised that he needs to let people know that he is going to be serving lemonade opposite the city hall this summer. So he spent on some flyers and signages. In actual businesses, advertisement costs are significant and one also has to deal with other expenses like sales commissions.

Advertising Expenses: 15 EUR (Flyers – 10 EUR; Signages – 5 EUR)

After few days, 40 lemons got spoiled due to the sudden spike in summer temperatures. In practice, loss of inventory due to theft, mishandling and storage are pretty common. Apart from inventory there can also be raw material wastage in certain cases.

Inventory Loss: 5 EUR (Additional expenditure to replace inventory)

One fine weekend, some of Johnny’s school bullies turned up and demanded lemonade for free. And young Johnny heeded to their demands. In practice, although in marginal cases sometimes clients do not pay up the last leg or delay the payments. This can lead to either deferred payment account or the interest cost of borrowing to fill in the cash demands.

Deferred Payments; 5 EUR (10 free glasses of lemonade, resulting loss of 10 EUR revenue)

Once the stall started doing well, Johnny had to seek help from his younger sisters in lieu of giving her some chocolates worth 15 EUR. In practice, HR planning is important as they account for a significant portion of operational costs – or even project costs in case of consultants.

Operational Expense: 15 EUR (HR Expense – Candies and Chocolates worth 15 EUR)

During the month of operations, two glasses got broken falling off the shelves while a few got scratched in regular wear and tear. Assets depreciate or sometimes get damaged in due course of time. Also, one may require to repair or upgrade capital assets in longer course of business.

Asset Write-off: 4 EUR (two broken glass – considering 1 EUR per glass)

Depreciation: 10 EUR (30% of 35 EUR Capital Costs)

Since Johnny was a smart kid, he had chosen a location on the sidewalk just outside the city hall. But little did he know that doing business requires permits, property taxes and more taxes. One fine day, two officers just doing their job, imposed a fine of 50 EUR for occupying the sidewalk.

Taxes and Fines: 50 EUR

Finally, let us calculate the profits Johnny made out of his lemonade stall: 26 EUR

Does not seem to be a lucrative option now. Just as little Johnny was unable to foresee various costs, many businesses fail to foresee the financial risks involved in establishing or expanding businesses. While shifting from wholesale to retail model, one may fail to foresee costs the complete picture; or while shifting from food truck to restaurant. Inability to foresee costs and subsequently analyse the cumulative financial effect of business decisions can lead to shrunk margins or losses.

Similarly, in any business, margins can be miss leading as they have to cover numerous expenses such as capital, interests, taxes, advertising, marketing, sales commissions, discounts, seasonal sales decline, salaries and bonuses, slack time, rent, taxes, admin costs, IT expenses, raw material price escalation and so on. To provide you clear visibility through bigger picture, financial projections and modelling are essential exercises that help the management make more informed decisions.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s