14 Modelling the business

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1 Modelling the business OBJECTIVES The main reason for developing a business model is to generate the financial forecasts that are a fundamental element of any business plan. But a business model also allows you to understand better the economics and drivers of the business and helps in the assessment of risk. It enables you to evaluate quantitatively alternative strategic options as well as assess the funding requirement. If sufficiently detailed, it can provide a tool for the day-today management of the business. APPROACHES TO BUSINESS MODELLING The most commonly used tool for business planning is a spreadsheet package such as Microsoft s Excel. The examples in Chapters and the business planning model that accompanies them (see page 145) have been built in Excel, although the principles apply to any spreadsheet package. A basic knowledge of spreadsheets is assumed in the following chapters, but if detailed help with business modelling is required see The Economist Guide to Business Modelling, which explains in full many of the techniques used. CHARACTERISTICS OF A GOOD BUSINESS MODEL A good business model should be: free of computational and technical errors; consistent with the assumptions made about the market and the strategy and tactics to be executed; capable of generating the results necessary to evaluate alternative strategic options; complete in terms of capturing all the relevant revenues, operating costs and capital expenditure items as well as any financing cash flows, including interest and principal repayments on debt or dividends on equity; cover the appropriate business planning time horizon and also the time period each year is broken down into, be it weekly, monthly, quarterly or annually; capable of easily running sensitivities and scenarios to test how robust the plan is in terms of unexpected changes in the environment; constructed to the appropriate level of detail. The length of the forecast The number of years to include in the business model and the number of periods each year is broken down into will vary between business planning projects. A small business should forecast a few years beyond the year in which it expects to start generating cash. As most small businesses will hope to begin generating cash within 1 3 years at most, a

2 Characteristics of a good business model 145 business model covering up to 3 5 years is usually sufficient. For large companies considering major investments the payback period may extend many years, and in such cases a ten-year forecast is usually developed. In uncertain markets, even forecasting three or five years is difficult and extending the forecast much beyond this point provides little additional benefit. Bankers and equity investors providing finance to small businesses will be interested to know when their money is required and for how long. In these cases it may be necessary to develop the model on a monthly or quarterly basis, especially if the forecast is for only a few years. If the business plan is intended to form the basis of the operational budget, a monthly-based forecast will probably be required. Otherwise a quarterly or annual forecast is usually sufficient. THE BUSINESS PLANNING MODEL The business planning model that accompanies this book has been designed primarily to help the reader understand basic accounting principles. The model can be downloaded from Readers with good spreadsheet skills will be able to modify the model for use in their own business. The model covers a ten-year period on an annual basis and generates a complete set of financial statements, including profit and loss account (income statement), balance sheet and cash flow statements, as well as various valuation measures and a comprehensive set of financial ratios. The model incorporates two product items and two items of stock as well as two customer segments, although only one product and stock item is used in the worked example. The model also contains the following: Staff cost calculations. Bad debt assumptions. Nine other operating cost categories that can be labelled by the user. Inputs for expenditure on physical capital, such as vehicles, as well as expenditure on intangible items such as patents and licences. Depreciation and amortisation workings for tangible and intangible assets based on the straight line method of depreciation, a concept addressed in more detail in the following chapters. Working capital calculations for debtors, stock, trade creditors and taxation creditors. Simple financing that includes a mixture of debt, equity or bank overdraft. Computations for interest charges, principal repayments and the interest earned on short-term cash deposits at banks. USING THE MODEL The model has been designed to be easy to use, even for those with little or no experience of Excel. To explore the model, select the version of the model entitled Blank Model. On opening it, click enable in relation to macros. A warning may also be encountered in relation to circular references. If a warning appears, follow these steps: click ok on the

3 MODELLING THE BUSINESS warning, close down any help messages that might appear, select tools from the menu bar and options, select the calculation tab, check the iteration box and enter 100 for the maximum number of iterations, then click ok. The model is menu-based and you can navigate between sheets by simply clicking on the appropriate button. Chart 14.1 shows the opening menu screen for the model. Chart 14.1 Main menu screen By clicking on a button, for example operational forecasts, the user is taken to the appropriate section menu. The operational forecasts section menu is shown in Chart Chart 14.2 Section menu The h button returns you to the main menu, and the arrows move you to the previous or next section the back arrow to the model set-up section and the forward arrow to the accounting section in accordance with the flow chart of the main menu. Within a particular subsection or sheet there are up to four buttons (a typical example is shown in Chart 14.3). The revenue sheet can be selected by clicking on the revenue button in the operational forecast section menu. Within a sheet, the h button will return you to the main menu, the c button to the section menu and the arrows move you through the subsections.

4 Using the model 147 Chart 14.3 Subsection structure Inputs for the model are entered in the appropriate sheets or subsections to provide context and for users to see immediately the results of their actions. User inputs are required in the boxes surrounded by a dotted line and all user inputs appear in blue. The model has been protected so that entries are possible only in the input cells. An example of user inputs can be seen in Chart To access the model set-up page from the main menu, select model set-up. The book uses (main menu model set-up) as a standard notation for guiding you in the use of the menu structure. Chart 14.4 User inputs An overview of the structure of the model and sheets within each section is presented in Chart 14.5 on the next page. The subsection or sheets in italics require user inputs.

5 MODELLING THE BUSINESS Chart 14.5 Model structure About the model Model set-up Operational forecasts Accounting Financial results About the model Model set-up Revenue Depreciation Profit and loss Cost of sales Amortisation Balance sheet Operating costs Working capital Cash flow statement Financing Ratios Taxation Valuation If you wish to turn off the protection to allow for further development, select tools on the main menu bar and then protection and finally unprotect sheet. No password has been used to protect the model. Within a particular subsection the sheet has been divided into two or four sections. Use the standard Excel scroll bars to ensure that the relevant columns are visible when reviewing results in the model. THE WORKED EXAMPLE As well as the blank version of the model, there is a fully completed version (Complete Model) of the worked example developed in the following chapters. The Appendix also contains all the sections of the model, representing the results of completing all stages of the worked example. Intermediate results arising from the initial stages of the worked example will not necessarily correspond to the results in the completed model. All stages of the worked example must be completed before the results will agree. A set of business planning assumptions is used for a fictitious company to illustrate the basic principles of accounting. You can enter the suggested inputs from the worked examples into the blank version to see how they flow through the workings of the model to the financial statements. Alternatively, you can simply follow the examples in the book and review the completed model in the Appendix. A scenario-style commentary on the worked example is provided to give some context. The fictitious company is Newco Corp, the first company to introduce the widget into the market of Newberg. Newco is a start-up company with no existing operations, staff, revenues or costs. As a result, the balance sheet at the start of the forecast period is blank. The widget is a mass-market product and revenues are expected to be in multiples of millions. The business intends to spend aggressively on advertising to raise awareness of the value of widgets among the population of Newberg. There is only one customer segment, but they can buy any number of widgets in the year. The one stock item that enters the widget manufacturing process is the zapper. A certain amount of manufacturing equipment is required to produce the widget, so a factory and workers are required. Some pieces of equipment are purchased and others are leased. The premises are rented. The widget is produced under licence from the inventor, so it is necessary to purchase a

6 The worked example 149 licence to manufacture it. The business is financed through a combination of equity, bank loans and an overdraft facility. Inflation and interest rates are stable as Newberg is part of a trading union, and its currency is the dollar. The stability of the dollar allows the forecast to be generated in nominal terms. Nominal forecasts include the effects of inflation such that the price of the widget in year 9 is the price the customer will actually pay in year 9. In contrast, in a real forecast all future figures are quoted in today s prices and the impact of inflation is excluded. USING THE MODEL IN YOUR OWN BUSINESS Although the business model that accompanies this book lacks the detail and complexity of more comprehensive models, it is more than adequate to generate an initial financial forecast for most small businesses. In the examples that follow, a number of rows that are not used in the example have been hidden. To view the full model including these rows, select the entire sheet, unprotect it, then select format row unhide. Hidden rows can be found in the working capital and profit and loss sheets. Readers who do not already have a business model but are skilled in business modelling can develop the model to meet the needs of their own business. For those with limited experience of business modelling and accounting, the remainder of this chapter may be best read once the next two chapters have been completed. Some of the more advanced developments that could be performed are described below. The model could be changed to a quarterly or monthly version. If the length of the periods is altered from an annual basis you must either adapt the calculations for interest, working capital and discount rates and so on to reflect the altered length of period or alter the inputs to accommodate this change in duration. A further change may be to enhance the revenue forecasting elements to incorporate the techniques covered in Chapter 12. Simple development options include increasing the number of customer segments and increasing the range of products sold. Additional stock items can be introduced. More sophisticated stock valuation techniques can also be employed, such as last in first out (lifo) or first in first out (fifo), which are discussed in the next chapter. Prepayments and accruals can be included. The model could be extended to include a dividend debtor account. The model could be extended to include different types of capital expenditure items and the number of depreciation and amortisation workings could be expanded to reflect assets with varying asset lives. The sophistication of the capital expenditure workings could be expanded to introduce the disposal of fixed assets and the profit or loss on the disposal. The taxation workings can be enhanced by limiting the length of time that losses can be carried forward.

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