What is a Financial Model?Dec 01, 2021
What Is A Financial Model?
One of the questions that comes up quite frequently, especially when we have a new client introductory meeting is what a financial model is. And really for me, a financial model is a focus on the profit and loss statement or the income statement and the three components that make up that individual statement.
Revenue is a result of selling products/services, and drives cash flow into your business. Your goal should be to continue to grow that revenue as long as it remains profitable.
2. Variable Expenses
Variable expenses are the expenses directly related to delivering revenue, and they go up and down in relation to revenue. So if you sell ten items your variable costs are going to go up as well.
3. Fixed Expenses
Fixed expenses are items that don't change month to month. A good example of that would be rent expenses, insurance expenses and other items that are fixed on a month to month basis.
So why is it important to understand what your financial model is? If you understand the correlation between these three measures, you will understand how you're able to grow and scale your business in a profitable way.
So really, what I want you to understand is revenue minus variable costs is gross profit. What we want is for our gross profit to continue to grow to as high a level as possible, so that when we deduct our fixed expenses are net income will continue to improve as well. As we continue to grow our profits, we can continue to have a greater impact with those that we serve.
So your goal is to grow your revenue, while making sure that your profit on delivery grows. Continue to work on your gross profit margin, which is the percentage of profit you deliver on each dollar of revenue, because as that increases, your bottom line income is going to increase as well.
Let's say that a business is making $100,000 and that they have a 50% profit margin. That results in $50,000 dollar gross profit. If there is an additional $20,000 of fixed expenses, that gives a net income of $30,000 dollar.
Here is how we would grow and scale this business to increase its bottom line income. Let's say we increase the revenue to $200,000, while maintaining the 50% profit margin, that would create $100,000 of profit. As our fixed expenses should not change, that will drive more and more profitability inside the business.
Now if that same business were to grow to $200,000 but the margin drop to 20%, we would only make $40,000 on that entire new level of revenue, and our profitability at the end of the day is lower. That is why it's important that you continue to drive a higher gross profit margin in your business so that you can impact your bottom line in a positive way.
The first step to understanding your financial model would be to really understand what your costs are associated with delivering on every dollar of revenue so that you can understand the gross profit margin that will drive bottom line profits to your business and will help you increase the impact that you're making with how you deliver your products and services.
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