How Financial Spreadsheets Help Entrepreneurs
Financial spreadsheets can become invaluable tools for entrepreneurs and help them to move their business forward. Using a spreadsheet offers the following advantages:
- Any change in assumptions and their effect on the result can be quickly calculated
- Calculations are easier to understand as full transparency on all calculations is provided
- Can interact with databases or any other tool using the data of a spreadsheet
- Spreadsheet programs such as Excel or Google Sheets can be shared with others or kept private
- Data can be displayed as Graphs
In the following, we shortly like to review the common use cases for financial spreadsheets.
The Importance of Cash Flow Projections
Cash is still king in any business. Accounting profits are subject to manipulation, especially as items such as depreciation & amortization, change in inventory are subjective to estimates. Cash is cash and therefore, much easier to grasp. So, financial analysts follow the cash when they do their financial analysis and evaluations. A financial spreadsheet with cash flow projections will serve as the basis for a business plan when talking to investors and banks. By analyzing the value drivers of a business, e.g. the company’s growth rate, profit margin, asset efficiency; one can better understand how a company works. Therefore, the financial planning process is a worthwhile exercise to perform, as you will get many good questions out of it and it will help you to understand and improve your business. Especially the analysis of larger investment projects which will require you to think through about potential investment alternatives which could be less costly or more beneficial to do. So, there is always a learning process which goes hand in hand with any financial analysis. Planning out expected cash flows is also very important for fast-growing Startups or high-growth companies who need to obtain visibility on their cash position going forward. They are mostly worried about the burn-rate and need to know early on what will be their funding needs. Cash flow projections also form the basis for a company valuation by e.g. using the Discounted Cash Flow valuation method.
Financial Spreadsheets for Cost Analysis
Entrepreneurs need to build profitable businesses in order to be successful. Therefore, a careful analysis of the costs is required to identify saving potentials and ways to maximize the company’s profits. In addition, Entrepreneurs also want to compare their cost structure with their competitors and other benchmarks. There are different types of costs – fixed and variable costs. By analyzing them, one can figure out the break-even point at which sales volume the company will be profitable. By running such analysis, the entrepreneur has a good chance to ask himself the right questions in order to identify savings potential or ways to enhance the company’s economics.
Financial Spreadsheets for Raising Financing
When dealing with investors and banks, a spreadsheet can become an important communication tool as well.
When a bank responds to a loan application, this normally is the result of a rationale exercise by looking at the merits and the risks from a financial perspective. Risks will be qualified by the available collateral and the covenants the banks’ lending committee needs to adhere to. Important bank covenant ratios are e.g. the following:
- Debt/EBITDA ratio – the ratio between the operating profit and the overall debt level. If it gets too high, the bank will refuse to provide more funding. This ratio is relevant for operating companies where there is no mortgage involved.
- Loan to Value (LTV) ratio – the ratio between the value of an asset (e.g. a property) and a loan. For residential real estate, this could be up to 80%, for commercial real estate more like 65%.
- Debt Service Coverage Ratio (DSCR) – the ratio between the Free Cash Flow available to service the debt (interest + principal payment). It needs to be minimum 1 plus a safety buffer.
So, what banks need to do, is to create a financial spreadsheet which explains the most likely cash flow scenario and the impact on the above covenant ratios. Therefore, finance professionals prepare for such discussions and calculate those ratios for the bank, in order to anticipate their questions and show them that their proposition actually is fully reasonable.
Entrepreneurs most of the time do not think like a bank and the miss the point here. That’s when the entrepreneur realizes at some point that the bank is talking a completely different language than them – by focusing solely on these financial ratios – without looking at the bigger picture. Well, that’s the bank’s job to protect the interests of their stakeholders and what they are supposed to do. The solution to that problem can be very simple. The entrepreneur is best advised to put himself in the shoes of the bank and by preparing detailed financial projections before approaching the bank, so he can actually anticipate the view of the bank and fine-tune his proposition to the bank’s needs. Therefore, a financial spreadsheet is the starting point to figure out how the bank discussion will go.
The job of investors is a bit riskier as they will invest in the equity capital of the firm. Also, they will need to have a more long-term view of the bank, as first, the banks get their money paid back and only afterward the investors. So, for Equity investors, the question is: How much do I have to put in and when will I receive the return on my investment?
Therefore, investors focus on key metrics of importance to them. In many cases, this will be mostly the Internal Rate of Return (IRR) while investors will also want to understand a company’s valuation. Here, the entrepreneur will have the best chances to obtain financing if he shows to the investor on how much the return will be and how this return will be linked to important key value drivers of the business. A financial spreadsheet which does the work FOR the investor can be a simple but effective tool to do so. The benefits of preparing such a spreadsheet are twofold:
- The entrepreneur is one step ahead by doing the calculations for the investor for them and has enough time to get all the arguments in place and think about responses to any counter-argument.
- It sends an important signal to the investor that his needs are understood and that the business will be professionally managed.
So, at the end of the day, a simple spreadsheet becomes a key tool to create trust and prepare for a meaningful discussion.
Company Valuations all rely on Financial Spreadsheets
Company valuations, especially when using the Discounted Cash Flow method or IRR analysis, all rely on financial spreadsheets containing several years of cash flow forecasts. Such valuations are subjective views regarding the value of a company and heavily dependent on their underlying assumptions. As such, its important to build such financial models bottom up and one can simulate how any change in important key assumptions will affect the company’s valuation. The better these spreadsheets are structured and the better the company is analyzed, the more meaningful the valuation exercise becomes. So, it’s worth to thoroughly research the data which supports or contradicts the assumptions taken and prepare a solid argumentation to defend the cash flow scenario, forming the basis for a DCF valuation. As a spreadsheet contains a set of formulas, there is full transparency provided on how a company valuation is derived. Therefore, spreadsheets will remain the key tools for performing company valuations.
Financial Spreadsheets – they are needed for Scenario Analysis
The advantage of financial spreadsheets as mentioned before is that they provide full transparency on all calculations. All numbers can be traced back to how they have been derived and therefore, the financial model becomes traceable. This is now especially useful when one wants to understand the different scenarios. The financial spreadsheet should be structured in a way so that it will be easy to change the key assumptions and run different scenarios.
Scenario analysis can be done when defining a downside case, a base case and an upside case. Any financial model will be inaccurate by definition, as it is only a simulation of reality. More important than the output is how the model reacts to a different set of assumptions and obtain an in-depth understanding of what will happen if a company performs worse or better. A real estate investor e.g. wants to find out how big would be the cash flow gap if a building is vacated by its current tenant and it will stay empty for 1 to 2 years. Depending on the result, he will then learn that it might be smarter to lower his rental price expectations earlier than when waiting for two years. A company preparing for a sale requires performing a variety of scenario analysis to simulate the effect of different strategies on the company’s valuation at the time of exit. By running those scenarios, the management can figure out different ways forward and will obtain an idea on what kind of valuation implications these scenarios have.
Let’s face it, running a profitable business is not as easy as a, b, c. It takes careful thought, many hours of research, and a lot of discipline making financial decisions. By using financial spreadsheets, decision making becomes more rational as one can understand on which basis a decision is made and compare different scenarios. Company owners will make financial decisions which are best for them, specifically which increase their equity value and returns. So, the criteria for decision making in finance can be e.g.:
- Net Present Value as a result of a DCF valuation, the higher the better
- Internal Rate of Return when making investment decisions, the higher the better
- Cash on Cash yield for investments when there is no exit in sight and IRR might not be the right measurement to focus on, the higher the better
- Payback period – the length it takes to pay back an investment, the shorter the better
- Breakeven – the length it takes so that a company becomes profitable, the shorter the better
When looking at best practices of larger corporations, basically, all of them rely on sound financial models to figure out which financial decisions are best for them and to justify them in a rational way in front of investment committees, boards, and/or shareholders.
Financial spreadsheets are essential for helping entrepreneurs to figure out how their company works. Although this may not be fully obvious to the entrepreneur, a well-built financial spreadsheet is needed for cost analysis, break-even analysis, budgeting, financial planning, cash flow projections, liquidity planning, also for decision making, raising financing, company valuations, investment evaluation and many more applications. In general, using financial spreadsheets allow entrepreneurs and key executives to obtain an in-depth understanding of the economics and by rationalizing the decision-making, enhance the quality of their financial decision-making process.
Financial spreadsheets are also useful when dealing with investors and banks, as they will need to understand the economics of the business in order to assess if the business generates sufficient funds to compensate them for the investment risk taken. A spreadsheet captures this in the most precise way, as a detailed bottom-up cash flow forecast can best explain a business in a language, finance professionals understand.
Of course, a thorough financial analysis can be time-consuming. Therefore an entrepreneur either needs to employ a financial analyst on his own, outsource the task to a consultant, or use a good financial model template. By making use of Excel financial model templates, it is possible to save quite some time and benefit from best in class financial modeling and financial analysis know-how.
Check out the inventory of financial spreadsheets available here on eFinancialModels.com.
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