The Traps of Avoiding Financial Modelling: A Lesson in Budgeting and Forecasting

While it might sound like an overstatement, in the realm of business, this rings truer than most. SMEs who overlook Financial Modelling will have some substantial drawbacks when budgeting and forecasting.

Budgeting and forecasting are the pillars against which operational decisions are judged and upon which those decisions are made. However, without a robust Financial Model, these decisions are usually taken based either on previous experiences, interpretation (perhaps misinterpretation) of the numbers, perceptions, or even personal beliefs. Most of the time with a short-term lens, far away from reality and without a strategic roadmap to follow.

At the heart of the issue lies the challenge of accuracy. If you rely on primary methods of budgeting and forecasting, such as simplistic percentage growth projections or vague estimations, you will often find yourself sailing in turbulent waters.

Imagine a scenario where a company solely relies on forecasting its P&L, projecting a modest 5% growth compared to the previous year. While the simplicity of this approach holds some appeal and it may seem plausible on the surface, it fails to account for the holistic financial landscape of the business. A mere P&L projection neglects crucial aspects such as liquidity, solvency, and the overall financial health reflected in the balance sheet and cash flow statement.

Let’s delve into some of the specific drawbacks faced by such businesses.

Inaccuracy Leads to Mismanagement:

Imagine a ship captain trying to chart a course without accurate navigational tools. Similarly, a business without a reliable Financial Model is bound to make poor decisions. Decisions that lead the business further from, rather than closer to, its target. That is, let’s label it, mismanagement. Inaccurate budgeting and forecasting lead to erroneous assumptions about revenue streams (amount and timing), expenditure (amount and timing), the amount of capital required and cash flow dynamics. This, in turn, can result in overestimation of profits, underestimation of expenses, and cash resource and cash flow crises. Without a clear understanding of their financial standing, businesses risk making ill-informed decisions that could jeopardise their survival.

Consider the case of XYZ Pty Ltd (a real example, though obviously not its real name). XYZ is a mid-sized Australian manufacturing company that neglected to adopt a comprehensive Financial Model. Relying solely on historical data and simplistic growth projections, XYZ found itself grappling with persistent cash shortages and cash flow issues. Without a clear forecast of future cash inflows and outflows, the company struggled to meet its financial obligations, leading to strained creditor relationships. The flow-on effects included an inability to acquire the raw materials needed for production, missed DIFOT targets and ultimately, dissatisfied customers. Meanwhile internally, morale hit an all-time low, resulting in lost staff and productivity.

The Three-Way Financial Model: A Non-Negotiable Asset

The peril of inaccurate budgeting and forecasting becomes increasingly evident when unforeseen circumstances arise. Market fluctuations, economic downturns, or sudden operational challenges can swiftly derail the best-laid plans of any business. It’s what happens next that matters. A business that is operating without a comprehensive Financial Model will struggle to take decisive action. In such turbulent times, enterprises equipped with a Three-Way Financial Model will understand the stresses these new circumstances will place on the business. They are able to direct their attention to the things that matter most and they are able to make good decisions quickly. They possess the foresight to navigate through adversity and are more resilient.

You might be asking now: what is a Three-Way Financial Model, after all?

The Three-Way Model is a holistic approach that integrates the balance sheet, P&L, and cash flow statement. Not only does it ensure the validity of the model, it provides businesses with a comprehensive view of their finances, enabling informed decision-making and proactive management. The Three-Way Model can offer unparalleled insights into the financial dynamics of your business, mapping relationships and highlighting dependencies.

Contrast the circumstances of XYZ with the success story of the ABC Pty Ltd (also not its real name!) – a client of BridgePoint Group. Recognising the importance of a Three-Way Model, ABC implemented a robust financial framework that encompassed all facets of their operations. Armed with accurate budgeting and forecasting tools, the proverbial canary in the coal mine, ABC navigated shifting cost structures with agility, seizing opportunities for growth while mitigating risks. The result? A profitable, efficient and resilient business poised for long-term success.

The Perils of Half-Measures

Despite the undeniable benefits of a Three-Way Model, many SMEs shy away from its implementation. This often resorts to half-hearted attempts at budgeting and forecasting. Or worse still, having nothing at all against which to plan and measure. This shortsighted approach generally stems from a lack of understanding or expertise in Financial Modelling, an aversion to investing a few dollars to do things right (yes, investing, since the benefits easily outweigh the costs), or a straight aversion to accountability. However, the consequences of such negligence can be very damaging and very wide ranging, as evidenced by the struggles of businesses like XYZ Pty Ltd.

Furthermore, the repercussions of an inadequate Financial Model extend beyond strategic planning. Prospective investors, prospective lenders and shareholders rely on accurate financial data to gauge the performance and viability of a business. The erosion of stakeholder trust and credibility put at risk your ability to execute strategic plans and achieve sustainable growth.

The drawbacks of avoiding Financial Models, particularly in budgeting and forecasting, are manyfold. And the consequences can be severe. If you want to embrace Financial Modelling as a cornerstone of your endeavours, reach out to us. We’d be happy to support you navigating the turbulent waters of business with confidence and success.