Financial Modeling: Important Metrics
Financial modeling can be considered to be the science of making informed decisions regarding a company based on data simulations. Most financial models pay keen attention to a variable such as revenue and expenses as well as their drivers. Data regarding these variables is extensively collated as well as analyzed. However, it turns out that the analysis of revenue and expenses is not enough. There are quite a few more important metrics which should be included within the financial models.
In this article, we will list down some of these key parameters.
Cost of Acquiring New Customers
The cost to acquire customers is a key metric that can prove to be a key factor, particularly in start-up businesses. This is the reason that this number should also be built into financial modeling assumptions. Cost of acquisitions is the total marketing cost divided by the total number of customers acquired in a year. For instance, if $50000 were spent and 1000 customers were acquired in the year, then the cost of acquiring a customer is $50.
Studies have shown that the cost of acquiring new customers does not remain constant across the years. As a result, the financial model must be adjusted to reflect the likely costs that the company may have to bear. To understand this better, lets assume that if a company has just started a business and created a new market, it will be relatively easier and cheaper for them to acquire customers since there is no competition. However, if the market is already established, and there are five or six competitors, then the price of customer acquisition will be high.
It is important for the financial modeler to use the correct acquisition cost per customer as input. This input can be used to double-check the amount which has been allocated for marketing.
Payback Period & Churn Rate
The above-mentioned cost of acquiring per customer does not make much sense unless it is compared to something. The cost of acquiring customers is usually compared to the profits that these customers generate. When these two numbers are divided, the result is called a payback period.
For instance, if the cost of acquiring a customer is $50, and the customer generates a profit of $100 per year, then the payback period is six months. This means that for the first six months, the company is not going to generate any profit from the customer, but later they will. Obviously, this also needs to be factored into the financial model. The number of customers that a company has within the payback period has a definite impact on the bottom line.
Churn rate is another important concept on similar lines. Churn rate refers to the number of customers who leave the firm within a given time period. Churn rate provides an important indication of how much a company should spend on acquiring customers. If customers leave the company in quick succession, then there is no point spending huge sums of money on marketing programs to acquire them.
Although these three metrics mentioned above are not seen directly on the financial model, they still have a huge influence. They are the main drivers behind the marketing spend of a company which accounts for a significant portion of the total money spent.
Cash Burn Rate
Start-up companies do not become cash flow positive from day one. Instead, for some time, they have to operate in an environment wherein their cash outflows are far greater than their cash inflows. This is not a sustainable state of existence. Companies cannot survive like this unless they find an external source of funding to make up for the gap.
The difference between the cash revenues that a company earns as well as the cash expenses which are paid out by the company is called the cash burn rate. Tracking this number is important since it tells the management how long the company can last with the current funding that they have. It is important for financial models to provide a clear picture of how different business strategies impact the cash burn rate. For instance, a marketing policy may be extremely effective. However, if it significantly accelerates the cash burn rate, the company cannot implement the policy until it has adequate funding.
Lastly, the liquidity position of a company should also be paid attention to while creating financial models. This can be done by monitoring the liquidity ratio. Many companies have target liquidity ratios. For instance, companies want to ensure that they have a cash ratio of one. This means that many companies always want to ensure that they have enough cash on hand to pay their next months bills. This can be built as a checkpoint in a financial model. This will help guide the creation of the companys policies.
For instance, if the company wants to implement a policy wherein they want to offer more credit in order to improve their sales, then they will have to ensure that they have enough cash on hand. This is because more credit would reduce the cash inflow of the firm. Hence, the liquidity position will be affected. There are various other ratios which need to be checked by the financial modeler to ensure that the policies being implemented by the firm are in line with their goals.
The bottom line is that focusing too much on revenues and expenses may not be as good for the firm. Other important metrics help in the creation of a better financial model as they help the management make consistent decisions.
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- What is Financial Modelling?
- Objectives of Financial Modelling
- Steps to Create a Financial Model
- Financial Modelling Heuristics
- Financial Modelling: Advantages and Limitations
- Why is Financial Modelling so Complex?
- The Future of Financial Modelling
- Creating a Revenue Model
- What is Cost Modelling?
- Important Decisions Influenced by Cost Modeling
- Financial Modeling: Important Metrics
- Scenario Analysis: A Primer
- Risk Management in Financial Modeling
- Modeling Discounted Cash Flows
- Debt Schedule in Financial Modelling
- Managing Assumptions During Financial Modelling
- Financial Modeling for Banks
- Financial Modelling for Insurance Companies
- The Merger Modeling
- Merger Modelling: The Accretion/Dilution Analysis
- Financial Modelling For Leveraged Buyouts (LBOs)
- Circular References in Financial Modelling
- Financial Modelling in Real Estate
- Why is Excel Not the Best Tool for Financial Modelling?
- Testing the Financial Model
- The Last Step: Handing Over the Financial Model
- How to Incorporate Ethical and Social Elements in Financial Modelling