Chapter 02 · Building a simple financial model
From revenue to profit
This chapter fills the top of the skeleton with a small company, so you can see a margin change reach profit, and so you can see where a single growth rate would have hidden the mechanism.
The company
A workshop sells one product. Last year it sold 10,000 units at ₹2,000, so revenue was ₹2 crore. Materials and direct wages were 60% of revenue, ₹1.20 crore. Fixed costs — rent, salaried staff, the depreciation you are treating as fixed for this sketch — were ₹50 lakh. Operating profit was ₹30 lakh. You are not asserting that next year resembles this. You are writing a base you can edit.
Two different ways next year can be ‘10% better’
| Base | Price up 10%, units flat | Units up 10%, price flat | |
|---|---|---|---|
| Units | 10,000 | 10,000 | 11,000 |
| Price | ₹2,000 | ₹2,200 | ₹2,000 |
| Revenue | ₹2.00 crore | ₹2.20 crore | ₹2.20 crore |
| Variable cost at 60% | ₹1.20 crore | ₹1.32 crore | ₹1.32 crore |
| Fixed cost | ₹0.50 crore | ₹0.50 crore | ₹0.50 crore |
| Operating profit | ₹0.30 crore | ₹0.38 crore | ₹0.38 crore |
In this particular sketch the two paths produce the same profit, because the variable cost is a pure percentage of revenue and fixed cost does not move. Change one assumption and they separate. Suppose the workshop is at capacity, and 11,000 units would require overtime that pushes the variable-cost ratio from 60% to 66% on the whole book. Units-up then produces variable cost of about ₹1.45 crore, and operating profit falls to about ₹0.25 crore. Revenue is still ₹2.20 crore. ‘Ten percent growth’ was a worse year. A model built on a single growth rate cannot say that. A model built on units, price, and a cost ratio can.
Where people type a story into the margin
The temptation is to improve the 60% because the company ‘should get scale benefits’. Maybe it will. The place for that belief is an input you can see — variable cost at 57% from year three, with a sentence beside it explaining which cost falls. The place for it is not a quiet edit you make because otherwise the profit looks too small to justify the price of the shares. If the only way the model produces a result you like is a margin you cannot explain, the shares are expensive relative to the business you can actually describe. That is a useful output. Do not debug it away.
Tax sits under operating profit, and it is not the cash tax
Apply a tax rate you state, to the profit it applies to, and remember that depreciation in the tax return and depreciation in your sketch may differ. For a first model, a single rate on operating profit after interest is honest enough if you label it as a simplification. The cash you hand to the tax department can also differ from the tax expense, because of timing. If you are not modelling that timing, say so on the sheet. A reader of your model — including you, later — is entitled to know which complications you left out.
What to remember
- Build revenue from units and price. The same revenue growth can be a better or a worse year depending on cost.
- A capacity limit that changes the cost ratio is exactly the sort of thing a one-line growth rate drops on the floor.
- Put margin improvements in the input block with a sentence, or leave them out.
- If the model only works with a margin you cannot explain, believe the model.
- Label the tax as simplified when you have not modelled the difference between tax expense and tax paid.