How financial modelling supports business expansion

One of the things that’s come up recently is around financial modelling. So I thought it’d be good for us to have a chat to understand how robust financial models can help decision making. Then from my perspective in corporate finance, what I see at least can challenge it, and then the tax piece, because the two have got to marry up, but don’t always do, and I think that understanding between us could be really helpful.

Okay, so what is a financial model then?

That’s a really good starting point. So financial models are a financial articulation of a strategy, which sounds quite complex, but what we try to do with a financial model is take the ideas, the strategy, the business plan, the input from lots of different people in the process, whether it’s the sales team, the finance team, the leadership team, or even external advisors, into one document and bring that through a journey.

Now that could be around strategic planning. So transaction is really common, which is where we probably touch base most, around transactions. But it can also be an investment decision, a new service line, or a new product line that they want to understand the impact of on the wider business.

So when I talk about financial models, an integrated one that looks at profit loss, the balance sheet, and the cashflow statement, because together all three are impacted in different ways by different decisions. And by understanding the three, you get a much better picture of what’s happening.

Okay, so what does the end product look like? What does the model itself, is it an Excel document? Is it different software? How’s it done?

Most of the models we build are in Excel, probably 90-95%. The reason being for Excel is it’s cheap. Everyone has Excel. Everyone knows what Excel is. Everyone is aware of it. So, the bit that we do, the clever bit of taking financial data and formula and creating an output, is what we can do, but everyone can then edit or understand and use the outputs. Also, by having access to Excel, we don’t have to worry about licenses for software, and it works to deal with complex situations.

The benefit of software though, is it can be really specialist, really bespoke, and some of the clever technology now that plugs into accounting software such as Xero or Sage or even QuickBooks, can be really helpful for the live day-to-day things. So, it’s what is your need and when you’re doing it is really important.

In terms of the “what is your need” Let’s say I wanted to expand my business overseas. Why would I use a financial model? Or how would it help me make that decision?

So, with expansion, there’s going to be cost involved. There’s going to be a time period between the decision, the first bit of expenditure, and the first return on that, and understanding those different points and how delays might impact that, can show whether it’s going to be profitable. Is it going to be profitable in the short term or the long term? Or both? Is it going to be a drain on cash in the short term, but cash positive in the future? And I guess that’s where I need your input on the modelling side of things, because the moment you go overseas, or the moment you start thinking about things, there’s so many different taxes that come out of the blue and they’re changing, and the “it depends” scenario becomes really important in models.

What should I be paying attention to from the tax perspective on a normal trading decision? I think if we look at a normal trading decision, so we’re going to expand or take on some finance, so it’s still UK based. Let’s not go overseas just yet, that’s a whole new layer of problems, what do I need to be thinking about?

We’ll start with Capital Gains Tax (CGT), because anytime you’re dealing with transaction or restructuring, there might be some CGT to pay. In the budget last year, the rates of CGT increased, so that could impact the amount of net cash that someone’s going to receive at the end of a deal. And then, I don’t know if you model payment dates for the CGT at all?

Occasionally. With that one, because we’re normally looking at a business decision and the business unit, the capital gains bit we layer on top. So, we can then use that to support the shareholders through their decision making. We move from a financial model into a sort of gross net and cash flow timing for the individual. So, it’s a look at the whole picture and a look at that total tax position.

You could then incorporate things like modelling the instalments then with that you can sometimes pay CGT in if there’s deferred consideration?

Yes, that could be really helpful, and understanding that cash flow can be the decision maker between the approach being taken.

One of the other things that I don’t know if you pay attention to is the Employers’ National Insurance contributions. Because those have obviously fairly recently increased, and I’m imagining that’s quite a big effect on your models.

Yeah, it does. Fortunately, we do model it, and we model it both from the employer’s perspective, but we also take into account a little bit of the employee’s perspective through PAYE. And having that ability to change scenarios within models, to change the assumptions at a granular level meant that, for the models that we built previously, which pre the changes that came in last year, we were able to very quickly adapt.

And I think that’s one of the key things when we’re looking at robust models is the ability to adapt to the changing world in which we live in. There’s so much uncertainty in the business world. There are so many different challenges. We used to have, we called it “Black Swan Events”, they were that rare; but now they’re happening much more often in the business world that they need to be modelled in and factored in. And that resilience of the business needs to be tested. Similarly a tax that remains fairly stable, but is quite challenging to understand is the VAT aspects. What do I need to be factoring in there?

Firstly, is your business even VAT registered in the first place? But let’s assume it is. I know you said we were staying in the UK, but for VAT it gets more complex when we start looking at overseas things as well. So partial exemption, if your business is making both taxable and exempt supplies then it can’t recover all the VAT it’s incurring. It can only recover the VAT incurred in relation to its taxable or its overseas supplies. So, there’s some type of calculation that needs to be done. Do your models go that far to look at exactly what you can recover?

Not necessarily. With most models, we have to find that balance between covering absolutely everything that could possibly happen, and the commercial rationale for it. So by building a model in Excel, we’re able to adjust the inputs and the outputs and the workings. Whereas a normal approach might be to not go into that level of depth. Businesses that are significantly impacted by it, we can add those layers of information to it, and factor that into the decision-making process.

So if you’ve got a business that is mainly taxable and is only doing a little bit of exempt for the purposes of your model, if you don’t think it’s going to make much difference, you just recover all the VAT in the model?

Yeah, exactly.

But if you’ve got one, conversely that’s mostly exempt, but just doing that little bit of taxable, so it is VAT registered but its recovery is quite minimal, you might just decide in the circumstances, you don’t need to go into that level of detail and model it.

Yes. For a financial model to be the best tool, it needs to balance the needs of the commercial, the financial, the tax, and find an outcome that is the least worst option in some cases. But to give enough information to decision makers to make the decisions they need to make without adding unnecessary complexity. For example, if we’re looking at an import-export decision. Absolutely vital. If we’re looking at a transaction where we’re trying to understand the potential cash flows, the outcomes of the business and the profitability, the impact of some of those decisions may be less relevant, so we’d focus on where we can have the most impact for our stakeholders.

Okay, but you’re still going to need a certain level of that knowledge, so that you know if it’s taxable or exempt that you’re dealing with in the first place. And then also on the international point to know if it’s just UK VAT that you need to be considering or if it’s VAT in another jurisdiction.

Definitely, and I think that’s where a joined-up approach between advisors is really important. The benefit we have at Price Bailey is you’re two desks over from me most of the time so that I can ask those questions. And it’s being humble enough to know when you’re building the model, who you need to talk to and bringing in that advice.

We understand Excel, we understand the modelling, we understand the accounting principles which are the building blocks for a financial model. But understanding the business, we’ve got to sit and we’ve got to engage with the clients to understand their business, they know it best, and bring their knowledge into an Excel document. And also bring the knowledge and expertise of yourself and our colleagues from around the practice to bear as well. You touched on overseas.

Yes.

Now you can’t really get away with looking overseas without understanding our colleagues across the pond with a massive introduction of tariffs and the changes that have happened.

Yes, I was about to ask about that. Are you seeing any impact on your models?

At the moment? No. It’s impacting decision making, but it’s not yet translated through to the modelling that we’re doing. But I think that’s because people are still coming to terms with understanding what the impacts are. It’s quite uncertain. So what are you seeing, that I should be taking into the next model?

There’s the increased tariffs now from the US, so ten percent on most goods. Whilst there’s the cash flow impact of that, there’s also the impact that you might have less customers or less demand as a result of people not wanting to pay that extra price.

Is it the ten percent? Or are there ifs, buts and maybes that may change that for people?

It’s not just ten percent on everything, that’s the flat rate, then different goods have different rates. Some are exempt, some are higher and it’s still changing. You’re seeing in the news every day that either there has been a further agreement made, or we haven’t quite got the exemptions that we wanted to get.

From my perspective, from modelling, the bottom line for us for a robust model is the cash flow, understanding the timing of cash, the inputs and the outputs and that long term survivability. So I think, from what you said and from my knowledge of modelling, is the impact of tax on models can both be very overt. We all know about VAT, we all know about Employers’ National Insurance. But it can also be quite covert. Tariffs are changing, a business growing might suddenly bump into tariffs unexpectedly. Or, if you’re looking at a transaction, CGT is absolutely vital to a seller but might not be on the radar of an FD or the finance team who’re helping prepare a model. For us to service both those needs, there needs to be an interplay between the model build, the tax elements, and the wider impact, so that someone can understand the overall picture.

If I were to take three things away, what are the three things that you think everyone should be thinking about when they start talking about modelling, when it comes to tax?

Don’t forget the VAT and Customs Duty. It’s very topical, and I know that we’ve said that sometimes you don’t need to model partial exemptions and the more complexities. But sometimes I’m assuming you do, because at 50% , recovery rate probably does make a bit of a difference. CGT, do you know what rate of tax you’re going to pay? Is there anything that you can do to reduce that or to help the timing of the payments? And a third one, I guess watch out for changes, so, things like the Employers’ National Insurance contributions going up. It does impact your cashflow, even though it might only be a small marginal increase, that adds up over a number of employees.

From my perspective, from a model building perspective, if I was to give those same three ideas, I think it is master the basics to understand your inputs and what really drives your business. Secondly, building off what you’ve said, be adaptable to change, don’t just find yourself fixed in one area. And thirdly, seek the appropriate advice. I’ve got user experience, but tax changes all the time and you are much closer to tax changes than I am. So, I think seeking that experience where we need to would be really important.