Chapter 01 · Building a simple financial model
A model is linked assumptions
A financial model is a set of assumptions that are linked so a change in one of them changes the statements all the way through. It is not a prediction, and it is not a value. This chapter builds the skeleton you can put on one page before you open a spreadsheet.
What the links are for
If you type a profit number, and separately type a cash number, nothing stops them from contradicting each other. A model makes the contradiction impossible by construction. Revenue depends on a volume and a price you typed. Costs depend on the revenue and on a margin you typed. Profit depends on those. The cash left at the end of the year depends on the profit, on the money tied up in stock and in unpaid bills, and on the plant you assumed the company would buy. Change the volume, and the cash changes, for a reason you can point at. That is the whole virtue of the exercise. A model that does not change when you edit an assumption is a picture.
The smallest skeleton
- A sales driver: units, and price per unit. Not ‘revenue growth’ as a single magic number, unless you truly have no idea what is being sold.
- A cost that moves with sales, as a percentage, and a cost that does not, as a rupee amount.
- Tax, as a rate you are willing to state.
- Working capital: how many days of sales sit unpaid, and how many days of cost sit in the warehouse.
- Capital spending: a rupee amount, and the years over which it is depreciated.
- Debt: what is owed, the interest rate, and whether any of it must be repaid during the year.
- The plug that makes the balance sheet balance. It should be cash or debt, and you should look at it. If the plug is a large unexplained number, the model is hiding a mistake.
Assumptions live in one place
Put every number you typed in a single block at the top. Everything else is a formula. The discipline is annoying for an afternoon and decisive a month later, when you cannot remember whether the margin was an input or a result. Colour the inputs. Do not type a number into the middle of a formula. A number buried in a formula cannot be listed, cannot be challenged, and will be the reason your future self does not trust the file.
| Lives at the top, as an input | Lives below, as a result |
|---|---|
| Units, price, variable-cost percentage, fixed cost, tax rate, debtor days, creditor days, capital spending, interest rate | Revenue, profit, tax paid, cash from operations, the closing cash that falls out of the balance sheet |
What to remember
- A model is linked assumptions. If editing an input does not flow through, it is not a model.
- Start with units and price, not with a growth rate you cannot explain.
- Working capital, capital spending, and debt are what stop a profit figure from pretending to be cash.
- Every typed number sits in one input block. Formulas contain no secret numbers.
- The plug that balances the sheet should be looked at, not hidden.