Every business decision carries potential risk as well as reward. The trick is to make more good decisions than bad ones. Naturally there is a lot of "gut feel" and intuition involved. Experience will play an important part, but the smart business person will also rely on the precision of mathematics and modeling to help remove some of the mystery.

A business model is a mathematical representation of the interrelationships of the various components of the business.

Perhaps a very simple example will help you see the power and understand the relationships.

In the following model we have a simple business with two assets (cash and receivables) and one liability (accounts payable). We also know that it takes on average 45 days to collect on receivables and all sales are made on account. However, we need to pay our payables in 15 days. We also know that our cost of sales averages 70% of the sales price. All of these mathematical relationships are built into the model. When we change the sales figure (the numbers shown in red) the model mathematically calculates every other number shown.

In the case illustrated we are showing great growth in sales driving the business into a cash crisis.

The model of your business will be many times more complicated than the illustration, but the principles remain the same. If the mathematical relationships are reasonably accurate, the model will predict the financial impact on the business profits, balance sheet and cash flow in the future.

As you analyze different assumptions and business scenarios, you will see with much greater clarity the expected business impact. Some plans that seem exciting at the outset can have financial disaster buried within them that a good model will clearly disclose.

Unfortunately, many small business owners have never had a good model of their business and are making decisions without the insight such a model provides.

So how do you create a model?

Here is one area where you are going to the need the expertise of an experienced accountant. Most models are extremely complex and rely on a thorough knowledge of the business and complete grasp of accounting principles. The following steps will help you understand what the accountant will be doing.

		First the modeling period and intervals should be decided. Usually working by months for a year are the easiest and most meaningful. The monthly periods will correspond to the normal reporting of financial information in most businesses.
		Compile historical information. A monthly balance sheet and income statement for the last year will help you determine the mathematical relationships. If your financial information is poor-the modeling will be much more difficult to do well. However, even a poor model will provide insights that make the effort worthwhile. One additional benefit of modeling is the tendency to improve historical financial information.
		List your key assumptions as you make them. The model will contain dozens of assumptions; so it is important that they be listed so you will remember them. A well designed model allows you to easily alter the assumptions as you analyze various business scenarios.
		First, model your income statement. It is best if you use the same categories that you show on your financial statements. Then it is easy to compare the results of your modeling against your actual results in the months to come.
		Second, model your balance sheet. Again you go item by item and make your assumptions based on the historical relationships between items.
		Finally, you model your cash flow.
		With the model in place, you now can begin to alter assumptions and see the impact on your income statement, balance sheet and cash flow. Your first model will usually not be very good, but as you compare it over the next few months to the actual results, you will be able to identify erroneous assumptions and correct them. It normally will take about three months of refining and comparing to actual results before the model will be a great and accurate tool for forecasting the future.

To model financial statements requires quite a bit of skill with a spreadsheet program and a good background in accounting. So don't hesitate to get the professional help you need to make it work for you.