Financial Modeling Part 2 – The Power of a Financial Model

0:00 All right. Last time when we started talking about financial modeling, we explained a few concepts.

0:05 The first is that a financial model is the mathematical representation of the inner workings of your business.

0:11 It's a model that has inputs or assumptions and produces outputs or financial projections which are forward-looking.

0:19 The power of that is that it's the only tool that allows you to see in front of you, to see the future.

0:25 It's almost like having a crystal ball if you build it correctly.

0:29 So now today what I want to do is I want to try to demonstrate to you the power of this

0:33 financial model and I'm going to do it through a fictitious company.

0:37 This is Troy's horrible attempt at humor.

0:39 I've created a fictitious company that is trying to make fun of the brogrammer culture

0:44 in Silicon Valley called Dollar Cave Club.

0:48 Everything you need to make your man cave.

0:50 So take a minute, hit pause and read about Dollar Cave Club.

0:54 Now that we're back and you've read about Dollar Cave Club, I want to show you the

0:58 mathematical model for it so let's take a look this is the mathematical model for dollar cave club

1:05 what we're looking at is the assumptions tab and you will see on this assumptions tab that there

1:10 are a bunch of things that we're assuming about the business and some of them should look familiar

1:15 for instance the very first one here which is the subscription price per month of 29.99 the next one

1:22 is the churn rate of four percent these were defined in the definition of dollar cave club

1:26 for you in the last slide.

1:29 This is kind of boring to look at, just the assumptions.

1:32 So what I'm gonna do is I'm gonna reveal to you

1:35 that I actually have two copies of this spreadsheet

1:38 or financial model open.

1:40 One I'm leaving on the assumptions tab right here,

1:44 as you can see, and the other one,

1:46 which is the same spreadsheet,

1:47 they're the same sheet connected live,

1:50 I have on the tab titled annual cash flow.

1:53 And I want you to take a look

1:54 in the bottom right-hand corner here

1:56 see that the annual cash flow results with this set of assumptions the projections say that we

2:01 have half a million dollars roughly 502 uh sitting in the bank at the end of year five and so now the

2:07 question comes how do we use this mathematical representation to do something interesting

2:12 well let's say we want to test pricing if we come over to our assumptions and we come over to the

2:19 price test and we say huh what would the business look like if the price were 33 percent higher we're

2:24 We're going to make it $39.99.

2:27 Now, as soon as I hit enter, since it's all in the same spreadsheet, it will recalculate

2:31 and it will show me the cash at the end of five years.

2:36 What do you think that cash will be?

2:38 I've increased the price by 33%.

2:41 Hit pause, think about it, and then come back.

2:46 So I hope you have a guess.

2:49 It'll be really instructive for you to have tried to figure this out.

2:52 The actual answer is that you don't have enough data.

2:54 You don't know what happens to my margin.

2:56 You don't know what happens to a bunch of stuff.

2:58 But many people would guess that the cash would go up by roughly 33% as well.

3:03 And they'd be wrong.

3:03 Watch what happens when I hit enter.

3:06 Wow.

3:07 The cash over here went up by 140%.

3:10 There's no way you could have figured that out without having a model that modeled out

3:15 all of your costs, all of your revenue over a period of time.

3:21 I'll let you guess at how it got there.

3:23 but we'll talk about that later. It's not actually fair to just say I'm an increased price and have

3:29 no ramifications. So we're going to go back to the assumptions page and we're going to look at it and

3:33 I'm going to use churn as a proxy for some things here. You see, if you charge more for your product,

3:40 the bar is higher for what your customers expect. I will assume that with a higher charge price,

3:46 I will have more customers who churn or are unhappy. So maybe instead of 4% churn,

3:52 And the churn's going to also go up by 33%.

3:54 And we can do that by changing the churn.

3:58 As soon as I hit enter, we'll see what happens.

4:01 Again, hit pause and think about it.

4:03 Do you think I'll be back at the 500,000?

4:07 Will I be above 500,000 or below 500,000?

4:10 I've increased price by 33% and I've increased churn by 33%.

4:15 Well, here's the answer.

4:18 I'm still way ahead.

4:20 You can see I have 863,000 instead of 500.

4:25 I'm over 50% ahead of the game.

4:28 Well, at what point does churn override the price increase?

4:34 What if churn is 6%?

4:35 How am I doing?

4:36 You can see I'm still at 700,000.

4:38 What if churn is at 7%?

4:40 I'm still above my 500,000 base.

4:43 When churn gets to around 8%,

4:45 oh, now you can see that I'm worse off. This enables you to create your first test for your

4:54 business. You see, we're going to create an AB test. Case A is $29.99, 4% churn. That's what we

5:02 said the business is doing today. Case B is let's increase the price to $39.99 and see what the

5:10 churn is if it's seven percent or less that is a winner if it's eight percent or more that's a loser

5:18 what you've just done is you've taken your business on that virtual test drive that we talked about

5:24 in the last video we've taken the car around the hairpin turn and we can see instantly whether the

5:30 car is going to be stable or going to flip hopefully this gives you a little taste of what

5:36 the power of a financial model is it enables you to change assumptions see what the ramifications

5:42 in the future even five years out will be and allows you to make better business decisions

5:49 in the next videos we'll talk about how you use this model to be a better entrepreneur

5:54 and run your business better and to be better at fundraising and we'll also talk a little bit

6:00 about how you actually build this complicated model so i hope that's helpful please send me

6:06 comments i would love to hear how we can make this better and more useful for you