The need for financial models to build a successful loan business

Lack of planning is recorded as one of the top reasons why 20% of businesses fail within the first year and 50% within 5 years. Going into business without knowing how you would make money or succeed is like leaving your house for an adventure without a map.

You could end up lost, wasting resources and ultimately heading in the wrong direction. So, when starting a loan business, you need financial models that would guide the direction of your lending goal and process. 

It’s a simple equation: every lending business needs a financial model because it helps lenders predict, avoid, and manage financial roadblocks. They present a clear representation of a company’s money situation, capital structure, day-to-day operations, strategy for attracting investors, and financial goals. 

Let us dive deeper into what a financial model is, the types, and how important they are to building a successful loan business.

What is a financial model?

A financial model is a mathematical representation of your business metrics and assumptions. It’s built with spreadsheets such as Microsoft Excel or Google Sheets. More often than not, lenders can predict the future of their business’s financial performance because the model relies on the company’s historical data and assumptions of the future to make its calculations.

The spreadsheet contains a summary of your company’s expenses and earnings using income statements, balance sheets, cash flow statements, and supporting schedules. Simply put, it’s the GPS of your business journey. And any errors can lead to costly mistakes.

Typically, it serves various purposes including:

• Business value estimation
• Competitor analysis
• Strategic planning
• Budgeting
• Resource allocation
• Stock performance
• Crisis forecasting

Professionals from various industries rely on financial modeling including commercial and investment bankers, public accountants, institutions in private equity, portfolio management, and research.

As we previously highlighted, financial models perform as business GPS for lenders to avoid roadblocks and predict financial performance. But there are more ways they empower lenders, including:

Tackle economic uncertainty

Financial models can use historical economic data and trends to explore various economic scenarios (for example, recession, and inflation). Lenders can foresee potential risks and adjust lending practices by stress-testing loan portfolios under these conditions. This proactive approach helps them go through economic uncertainties.

Develop backup plans from foreseen vulnerable points

The modeling process seeks out vulnerabilities in the loan portfolio, such as over-depending on specific borrower segments or loan types. For example, exploring why people do not pay back their loans can inform plans on the best loan collection methods, what kinds of borrowers to loan money to, and how to work with struggling borrowers. Other plans include diversifying loan offerings, adjusting creditworthiness criteria, or setting aside reserves to handle losses.

Customize services to meet the needs of borrowers

Financial models can analyze borrower data to understand their needs and risk profiles. This allows lenders to tailor loan products with suitable interest rates, repayment terms, and collateral requirements. This customization improves borrower satisfaction and casts a wider net to attract customers.

Capital budgeting

Financial models help assess how profitable different lending activities are. They project future loan origination volumes, interest income, and potential losses. This information guides decisions on how to share resources, such as staffing for loan processing or marketing budgets for acquiring customers/borrowers. 

Attract and manage investors

Financial models paint a clear picture of the company’s financial health. Lenders need these models to convince investors of potential profits and risks. Realistic assumptions would build confidence and attract capital. In addition, lenders can use the model to manage expectations by showing how different market conditions can affect profits.

There are different types of financial models for loan businesses. Each have their unique ways of making you money, evaluating inherent risks, and significant opportunities that drive how you use them, what technology to adopt, and how much it costs to own at small and large scales. These financial models include:

Buy-Now-Pay-Later (BNPL)

This model relies on small transactions with short repayment terms. In terms of tech, it significantly relies on mobile-first technology and payment gateways for smooth transfers, collections, and user experience.

Retail loan

This model provides larger loan amounts with longer repayment periods to individuals. To operate this model, you would need to invest in CRM tools and loan risk assessment practices and offer customized loan options.

Small Medium Enterprise (SME) loan

This model has more flexible loan structures for small and medium enterprises. To operate, you would employ a mix of online platforms for forms and document submissions, customized loan options as well as relationship management. Check out how to avoid SME loan defults as a Nigerian lender here.

Invoice factoring

This financial model allows businesses to sell their unpaid invoices to a third-party factoring company at a discount in exchange for immediate cash. This way, businesses can improve their cash flow without waiting for customers to pay their invoices, which can have payment terms of 30 to 90 days or longer.

Distributor financing

This financial model involves supplying distributors with loans to purchase goods/inventory from a manufacturer, and then receiving the loan repaid with an agreed-upon interest rate. When a trade is effected, it creates value along the supply chain. The manufacturer benefits from faster inventory movement and quick payment, the distributor can keep his business running with easy access to goods and profit despite not having the required capital initially, and the lender benefits from the interest rates, established relationships in the manufacturer’s network, and more credit-worthy customers.

We explained how to configure Lendsqr to power distributor financing here.

Asset financing

This allows businesses short on capital to request loans using the assets they own as collateral. Such companies access capital by using their balance sheet assets, such as short-term investments, inventory, and accounts receivable, as collateral for loans. This is particularly useful for companies that may not qualify for traditional unsecured loans due to a lack of credit history or insufficient cash flow. When the company defaults, only assets pledged would be seized instead of the entire business.

Validate, review, and run tests many times. If it fails, run away

Before you settle on one, your business model must have a way of testing at a smaller scale to validate the financial model you choose. This will help you identify hiccups and protect your business from pocket-denting mistakes before going large scale.

Although Microsoft Excel is a staple in financial modeling, they are exactly that when dealing with complex financial models – soft. Excel sheets can hardly compute real-life situations such as extreme currency fluctuations, competitors entering the market, and so on.

Predict your future, and pave the way for success

Financial models are invaluable tools for lenders planning to build a successful loan business. With this tool in hand, lenders can wade through different economic conditions and choose the most profitable and rewarding business model.

Instead of simply hoping for the best, lenders can control the narrative more effectively. Send us a message at [email protected] to find out more.