top of page
  • Writer's picturePeter Geh

The Fundamentals for Creating a Budget (Financial Model) for your Small Business

Updated: Feb 7

As a professional accountant and fractional CFO, I'm frequently asked about financial modelling. To summarize my position quickly, I think they are critical to above average business success. As a result, I want to share my thoughts on the fundamentals to financial modeling to help small business owners.


Fundamentals for Creating a Financial Model for your Small Business

Why You Need Desperately Need a Financial Model


First of all, the most fundamental thing in financial modelling is understanding why you actually need a financial model. If you Google "Goals % chance of success", you'll be flooded with articles about how the most successful people set goals and how your chances of success could increase by 20%, 30% and maybe up to 50% by writing down and establishing goals.


I guess it's no secret that goals will help your chances of success but all too often I find business owners have very little in the way of established financial goals. Business owners often tell me, "I want to grow my business", and my response is always, "Oh yea, and by how much and what would make you happy?". Unfortunately, I rarely get a concrete well thought out answer, and for me, that's a problem because I know they likely won't be as successful as they could be. Financial modelling for me is like setting financial goals for your business.


Creating Your Small Business Financial Model


Step 1 - The Tool

For most small businesses, a simple tool like Excel or Google Sheets is going to be just fine for your financial model. Excel and Google Sheets are ultra flexible and that's why these tools are still what most businesses use today. As a plus, even if you aren't an expert with these tools, there's a TON of help articles online for pretty much everything. FYI, as your business grows and gets more complicated, I wouldn't be thinking, "what other software's are out there to help me" or "how can I get better at this", I would be thinking about hiring someone to help you so you can focus on your business. As your business grows, you've got to offload certain tasks so you can focus on how you can provide the most value.


Step 2 - The Base

A tower is only as strong as its base. If you have solid bookkeeping and up to date records, this is great as your base figures are reliable. Of course, if you don't have great bookkeeping and you aren't up to date, you need to get that sorted out because you can't project into the future without knowing where you are at.


I would export at least 3 months of monthly data to Excel or Google sheets. With that data, critically analyze it considering whether these months are normal for your business. You might have a seasonal business, you could have been impacted by things like the Covid 19 pandemic, etc. Adjust your base figures reasonably and as necessary.


Step 3 - Start with Revenue

It doesn't matter what type of business you have, you should always start by modelling out your businesses revenues. Spend some time here considering relevant assumptions that are key to your business. Think about things like:

1) Historical growth rate. Is that right? Should or could it be higher?

2) Price. Could that increase at some point in the future? It should if costs are going up.

3) Demand. What's my industry doing?

4) Market share. Are there lots of opportunities for growth or is the competition fierce?

5) If you are a start up, think about things like your "Total Addressable Market".


As the business owner, YOU are the best person, the "Expert" to be able to answer these questions. Any financial professional including myself would be asking you similar questions if I were tasked with modelling your business. Once you collect your thoughts, start entering the assumptions into your model (IE, your prices, number of units you want to sell, growth rates, etc).


Step 4 - Cost of Sales

If you are manufacturing things to sell or you are retailer, you will have cost of sales. Again, it's all about taking some time to think about your businesses assumptions. The good thing here is that you've already thought about your revenues and costs are typically a function of that. As a result, think about things like:

1) Can you determine what your "standard cost" of manufacturing is? IE, what's the typical cost of building something and / or installing something including materials and labour? Plug these numbers into your model based on your revenues. FYI - This is also a great exercise to understand and confirm your gross profit margin.

2) For retailers, you should have some general guidelines of your markup across each major product category. Using these markups to determine costs of sales based on your revenue assumptions is the best way to go about projecting your costs.


Step 5 - Operational Expenses

Operational expenses are things like advertising costs, rent, utilities, general wages and benefits, repairs and maintenance, banking costs, etc. If you are already operating, much of this information is already in your base numbers. You should have a pretty good idea of what they are. If you are a start up, lots of this information can be found online if you look for the information. However, based on your revenue projections, certain costs scale differently and you should think about how the costs will change for your business. Consider the following examples:

1) Advertising and promotion - This is a leading cost (meaning you spend a month or two before you actually see sales increases) and generally advertising and promotion increases based on the sales you want to achieve. You might even find it wise to read up on "Customer Acquisition Costs" and project the costs that way.

2) Banking and credit card charges - These are generally a function of sales and they go up over time as sales increase since they are based on a percentage.

3) Inflation - Naturally everything is going to go up in price, you should make some assumptions regarding things like utilities, property taxes, strata fees, etc, you name it.

4) Wages and Benefits - Based on your revenues, how many people are you actually going to need? This ones tricky, spend some time on it to come up with some reasonable thoughts.


Finalizing and Working with your Model


Building a financial model isn't as hard as you think. It will take some time and patience but you can put something together. It might not be as pretty or as functional as what a professional might put together and you could miss things, however, at least you have something where you've mapped out your financial goals. Here's some other best practices for your financial model:


1) 3 Years, that's it.

Don't bother modelling more than 3 years. After 3 years, it's mostly guess work. I would suggest 2 to 3 years for your financial model.


2) USE your model.

After you invest time in your model, please, actually use it. You will get valuable insights into your business when you compare what you thought was going to happen versus what actually happened.


3) Update you model.

I recommend that on a quarterly basis you review and update your financial model to reflect changing assumptions. This is super important to keep your goals current, your model should be fluid!


4) Set appropriate goals.

Your assumptions / goals should be stretch goals, IE, not too easily attainable. If you find that you're always meeting or exceeding your modelled financial goals (or falling short most of the time), set your targets / assumptions higher or lower and spend time figuring out how to achieve those revised goals. Remember that the whole point here is to maximize your businesses potential by striving for what you want.

Comments


bottom of page