How Financial Modeling assists in business decision making?

Financial Modeling for Business Decision Making

Financial modeling helps in business decision making

Ravi is an entrepreneur. He is the founding member of a social media venture. He, along with 2 of his friends, pooled money from their savings and started this venture. The initial 2 months were spent on getting the website up. The first 3 months after launch were difficult as there were hardly any visitors to the website. But as the information of the website spread, the traffic on the website started increasing and soon the website was well-recognized in the student community. 

With the new-found success of the website, few investors started approaching them with offers to invest in return of equity in the firm. Ravi was convinced that the business has potential to expand further. And this would entail more funds. But none of the founders were in a situation to get more funds. So, if the founders take funds from external sources, they will have to dilute their stake in the company. And Ravi’s partners were not ready to divest the stake and preferred to keep the business small.

Ravi, on the other hand, is determined to convince his partners that the profits generated by expanding the business will more than offset the perceived “loss” by stake sale that his partners are evading. Ravi has some background in financial modeling since he was a financial analyst before he embarked on his entrepreneurship journey. He started building a financial model. The venture was now more than a year old during which time Ravi and his partners had maintained the monthly records of sales and costs. Using this monthly data, the historical model was built. 

The business had managed to break-even at operational level i.e. revenue was exceeding the operating costs. However after incorporating the initial setup costs, the operation was still loss-making. So cash infusion was still required by the business. Ravi computed the “Burn-rate” i.e. the rate at which cash infusion is required by the business and estimated that at the current rate, the business can function for 6 more months without additional cash. 

Based on his understanding of the social media space, Ravi figured out the areas that the business could focus over the next year. He estimated the likely revenues that could be accrued by venturing into this space. He also estimated the likely additional cost in terms of marketing, developmental efforts, etc. He figured that the profits could jump 5 times over by the next one year. 

The next step was to estimate the alternate cash sources that could help in this situation. One option was getting new investors. But this would mean parting with some of the profits. Another option was taking a loan from the bank. The bank loan will entail additional interest cost at a high interest rate since start-ups are risky ventures. Also banks may not readily fund start-ups. He included both funding options into the model and added scenarios to the model to account for both these options. 

decision making steps using financial modeling

After working with different assumptions and performing sensitivity analysis, Ravi came to the conclusion that equity dilution was the best option. However the extent of dilution and the funds acquired during the process was crucial. So based on the expected cash flows, Ravi estimated the valuation of the firm. With the amount of funds needed for expansion already calculated, Ravi realized that they will have to dilute less than 10% of their stake. And this would mean negligible reduction in the profits for the partners in the future.

With his financial model complete and ready to handle different scenarios, Ravi was confident that he will be able to convince his partners to go for stake dilution to help the business grow.