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Exploring The Role of Financial Modeling in Scenario Planning

Financial modeling plays a pivotal role in scenario planning and the development and evaluation of alternative strategic paths for any organization. The visual representation and potential performance scenarios of a company’s financial position enable organizations to better conceptualize future financial possibilities and make better and more informed strategic choices. In this piece, we explore the role of financial modeling in scenario planning, sharing use cases across industries and considerations when building financial models. 

Use Cases for Financial Models 

Financial modeling serves as a versatile tool that can be applied across any industry. Beyond charting growth opportunities and identifying operational efficiencies, it also allows businesses to optimize resources, mitigate risks, and ultimately maximize the value of their assets. 

In a recent engagement, Clarkston worked with an organization to assess and evaluate different strategic paths the brand could possibly take as it pursued its growth ambitions. The client recognized that it needed to reimagine its growth strategy while ensuring the path forward was rooted in financial discipline and structure. Looking to manage costs and increase profit margins are a few common reasons to build a financial model. This ultimately helps to provide insight, ranging from how revenues may evolve based on internal or external factors to how changes in cost structure could improve profit margins. 

Company valuation is another frequent use case for financial models. Whether a valuation is appraised through multiples (e.g., EBITDA- or revenue-based), discounting of future cash flows, or both, it’s vital for the acquirer as well as the target to put reasoning behind the value they believe is fair.

The Critical Role of Liquidity 

Effectively managing liquidity is imperative to ensure a business’s ongoing operations and financial stability. A deep understanding of financial statements serves as the foundation for creating exhaustive financial models, ultimately leading to better liquidity management. Financial statements provide a comprehensive snapshot of a company’s financial health. From a liquidity standpoint, the statement of cash flows delineates the movement of cash in and out of a business – any gaps in cash inflows and cash outflows can signal potential liquidity constraints.  

Financial modeling provides a range of views depending on needs. Not only can it offer a glimpse into the anticipated profitability for the upcoming years, but it can also show the company’s cash position for the same timeframe. By harnessing data from financial statements, we can simulate diverse liquidity scenarios, effectively allowing us to tweak variables – such as those based on better supplier payment terms – to gauge the effects on liquidity. 

For example, Clarkston recently worked with another client who was trying to figure out its future strategy for an underperforming asset. While future cash flows looked positive, the client fell significantly short of the investments the company had made for over a decade in trying to turn the division around. As such, the fundamental question became one of product-market fit and the willingness of the organization to continue to spend time, energy, and money on an asset that had a mild prospect into the future.  

Considerations When Building Financial Models 

Many factors can impact the outcome of a financial model. First and foremost, it’s crucial to develop a baseline model using a company’s current financial and operational data, from top line (revenue sources) to bottom line (costs involved in running the business). Secondly, the drivers and assumptions for the model should be documented to summarize what levers will have the biggest impact on future scenarios. Finally, a strong grasp of the industry and the competitive landscape is vital to understanding the various factors that may impact operations – including taking a broader viewpoint and ensuring macroeconomic implications are accounted for. 

Each input, such as revenue growth and gross margin, influences the financial model in a specific way. For example, higher costs in raw materials would decrease the company’s profits. The only way, in this situation, to maintain gross margin would be to increase product pricing, although this may hinder sales growth depending on the product’s elasticity. Financial modeling therefore often requires the use of various scenarios to properly capture and analyze the potential outcomes and contingencies. This approach allows for assessing the model’s robustness and adaptability in different circumstances. 

For another client, Clarkston modeled what increases in productivity and the Salesforce organization could mean for a burgeoning product/service market entry. In doing so, our client was able to visualize the potential impact on the P&L across multiple scenarios and select one that the executive team collectively felt aligned with the company’s capabilities.  

It’s worth bearing in mind that while past performance can help provide a forward-looking picture, it doesn’t guarantee future results – as mentioned, there are endless factors that can impact business performance in ways impossible to predict. To effectively address these unpredictable factors, employing stress testing in the form of what-if scenarios tends to be the most prudent approach. 

The Importance of Financial Modeling for Future Planning 

The multifaceted importance of financial modeling is clear, demonstrating how it empowers businesses to navigate uncertainty, optimize resource allocation, and ultimately drive sustainable growth.

Our strategy and innovation specialists also have the financial expertise to evaluate your company’s current financial status and suggest corrective strategies to enhance its health. Additionally, we offer comprehensive guidance through a growth phase, whether via the acquisition/sale of an entity or the implementation of internal/external transformations that foster expansion, all of which will be exemplified through financial modeling. 

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Contributions from Carson Cutright

Tags: Strategic Advisory