Financial Model vs. Operating Model

One of the more valuable things that I think I contribute is that I’ve worked on both sides of the table.  I’ve been an operator for almost eight years now. Prior to that I spent about five years in financial advisory and investment management roles, and another four years in consulting.

This background gives me some perspective about the modus operandi of different stakeholders in a business.  

In my prior role, our original founder (President & CEO at the time) wasn’t quite sure about that.  He had an entrepreneurial background without a lot of exposure to private equity investors. Over time though, I think he came to realize that having someone on the team that thinks a lot like our backers is pretty useful.  My next two CEOs both had considerable experience with private equity investors, and I think my background was a big plus in their eyes. Simply “speaking the language” is certainly a confidence builder and can help bridge some divides.  

Which brings me to the point I want to make here.  I still see a fairly different approach to models. And due likely to some fundamental misunderstandings of how they’re going to be used.  

I recall my first close.  Our CFO at the time sent me the ledger output and asked me to run it through what we were using as the “operating model” at the time.  So, I dutifully did. I blew out the existing values and added the new values and proudly came back to him and showed him the results.

He asked, well how did that compare to the forecast?  Yes, the forecast I had deleted and not saved. I only made that mistake once, but it was a valuable lesson in the difference between a financial model and an operating model.  Having really only run financial models as an investment banker, the operating model was not something I understood..

A financial model is mostly static.  You build it. You add your inputs. You look at the result – mostly the full year numbers – maybe out a few years.  The full year numbers are the major output. You do some y/y comparisons. But the long term values are still the key output.

Many times the financial model may be simplified (all models are simplified to an extent) in a way that standardizes the inputs and outputs across different types of businesses.  And this makes sense. Sometimes customized “helper” tabs have more company specific drivers, but in may cases those are shoehorned into the model. This is all fine. It’s a short-term work around.  

The model might be an annual model, quarterly model, or sometimes monthly.  But anyone who has spent time forecasting knows that the resolution at a monthly level a few years out is gibberish.  The only thing I am 100% sure about in any of my forecasts, is that I am off. I just don’t know the direction and magnitude.

The financial model probably has a robust set of ratios and metrics.   All of these are useful to some businesses. But all are not useful to all businesses.  This is also fine, as the financial model generally is a one size fits most type of product.

An operating model is a living, breathing, evolving creation. It’s as much a thing as it is a process.  It’s very much customized to your businesses. And, you’re going to live with it a long time and update it a lot.  Monthly or maybe more frequently. My operating model in my last role had over ten years of monthly data and I had been evolving it over almost seven years.  

And the short-term comparisons are the key output.  Comparisons to prior year, prior month, forecast, and budget (not necessarily in that order).  

I’ve been working with the operating team of our investors to setup a new reporting package.  They are much closer to understanding an operating model than others. But they’re still missing some key points.

Budget was still dynamic.  They rolled December forward and my budgeted balance sheet and cash flow statement moved. No, paste values.  My budget never changes at this point.

And where’s the spot for my forecast?  And comparison forecast? Non-existent.  Forecast does not equal budget, not even in January.  I know more about my business at the beginning of January than I did when the budget was approved in mid-December.  I still find forecasting the month and comparing actuals to my forecast, the best way for me to see if I have a good handle on the dynamics of the business.  Even if no one else wants to see it, I do it for myself. The last CFO I worked for didn’t want to see a forecast. Red flag. To be fair, our CEO never really asked either. Red flag.

What about prior month?  My current business is pretty dynamic.  We’re growing fast. We’ve made a lot of changes.  My trend to last month is probably the best way for me to see something changing.

And ideally on one page.  Keep it simple. I don’t need twelve tabs of every financial ratio you read about in a text book.  If I have to look up the ratio on investopedia, it’s not going to be useful to me on a monthly basis.

I want to peel the onion.  Provide a digestible snapshot.  This is not every line of the ledger.  This is not my expenses in three categories (G&A, S&M, R&D).  Usable. You will know it when you see it.

And, pop the important variances.  Easy to see. Depending on your business, this might be dollars, percent, or per unit.  But it probably isn’t all three. Pick the most important.

When I stepped into this role, the private equity team was running the operating model (I’m not sure they we’re running it like I mean, but they said they were).  For some reason they didn’t want to hand the model over right away.

One, if the PE team is running the operating model and the operating team isn’t asking for it, you’ve got a problem.  That’s abdication, imho.

Two, if the operating team doesn’t have an operating model, they’re steering using the rear view mirror.  Or using a financial model for the wrong purpose, so the feedback loop is going to be too long. Hand over the model.

When I didn’t get the model by week two, I went home that weekend and built my own.  I’m not doing my job without it.

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