Introduction
Financial models can be used to project future performance of a business, startup or product, and are used by many prospects of venture capital, private equity and lenders when evaluating a potential investment. Their purpose is to give a simple and clear meaning to the financial picture of a start-up and helps its investors understand financial performance better. In this blog post, we will be discussing the benefits of building financial models for startups.
A financial model is composed of various scenarios at different stages of a startup’s development. A comprehensive financial model helps startup founders and investors predict long-term trends, analyze risks, examine potential scenarios and make needed adjustments if the conditions suddenly change. To build a financial model, an entrepreneur has to take into account factors such as cash flow, revenues, expenses, capital requirements and profits.
Benefits of Financial Modelling
- Provides clarity and challenges assumptions
- Levels the playing field between founders and investors and allows you to push for more favorable terms
- Engages stakeholders with transparency
- Identifies opportunities and risks in advance
- Sustainability evaluation
Key Takeaways
- Provides clarity and challenges assumptions
- Levels the playing field between founders and investors
- Engages stakeholders with transparency
- Identifies opportunities and risks in advance
- Sustainability evaluation
Defining Assumptions
Financial modeling is a necessary tool when starting a business. Before a business plan can be accurately presented to potential investors, a financial model must be built in order for both parties to understand the cash flow. Defining assumptions and projecting revenue and expenses are key steps in this process.
Set Up Projections
Once the business plan and operations plan have been established, you can begin to build the financial model. This will involve setting up projections for at least three different years. The projections should detail cash operating activities, capital investments and planned debt activity.
Develop Base Assumptions
The next step is to develop base assumptions that will determine the projected revenues and expenses. These assumptions should include things like customer growth rate, customer acquisition cost, customer lifetime value, customer churn, gross margin percentage, cost of goods sold, number of products, as well as operating costs, taxes, and other fees.
Identify Revenue and Expense Drivers
Once you have established the base assumptions for your financial model, you can now identify the key revenue and expense drivers. These drivers are the core sources of your income and expenses, and need to be planned out carefully. Examples of revenue drivers include customer growth rate, customer acquisition cost, customer lifetime value and customer churn. Examples of expense drivers include cost of goods sold, production cost, operating cost and taxes.
Nailing down the key assumptions and drivers of your financial model will help you accurately project revenues and expenses, as well as giving you a better understanding of the financial health of your business. For more detailed tips on financial modeling, get in touch with a team of experienced business advisors.
Building the Model
When building a financial model for a startup business, it is important to carefully evaluate the inputs that provide the basis for the analysis. There are three main components of the financial model: the income statement, the cash flow statement, and key financial ratios. Let’s take a look at each part of the equation.
Create Incomde Statement
A well constructed income statement should project out the revenues and expenses the business is expected to incur over the given planning period. Potential items to include are sales, cost of goods sold, operating expenses, and other income or expenses. Start by adding the projected sales figures for each month. Then, project expected expenses. It is important to be accurate here since this will impact all other calculations.
Create Cash Flow Statement
In its simplest form, the cash flow statement lists out sources of cash flow and its uses. One method of constructing the statement is to start with the income statement and then make the appropriate adjustments. Consider factors such as inventory changes, accounts receivable, accounts payable, and capital investments. Make sure to start with the net income line and then make adjustments to arrive at the cash flow number.
Calculate Key Financial Ratios
Once the income statement and cash flow statement have been constructed, financial ratios can be calculated. Ratios such as cash flow to sales, current assets to current liabilities, and net income to assets are commonly used to evaluate the performance of the business over time. Ratios can also be used in creating debt and equity capital structure scenarios.
By creating an income statement, cash flow statement, and then calculating the appropriate financial ratios, entrepreneurs can have a complete financial model to evaluate their startup's potential. It is important to review the assumptions in the income and cash flow statements regularly and make adjustments as necessary.
Forecasting
When building a financial model for a startup, it is important to create a forecast and adjust it over time. Forecasting can be used to predict sales and expenses, forecast a cash flow, and monitor progress over time. With careful forecasting and monitoring in place, startups can be prepared should financial problems arise.
Forecast sales and expenses
Before anything else, startups should develop an accurate forecast of sales and expenses. The sales forecast helps startups anticipate when, where, and how much they will sell in the upcoming months or years. The expense forecast helps them plan for upcoming payroll, taxes and other costs. Creating this forecast and understanding the associated trends are essential for determining a company’s overall financial health.
Forecast cash flow
Forecasting cash flow is a crucial step in business planning. Cash flow forecasting provides a view into a company’s expected total asset balances in the short and long term, and is used to anticipate when money will be coming in, predict when money will be going out, and ultimately plan for potential growth or cash shortages. That way, startups can plan ahead and have a more accurate budgetary picture.
Monitor progress
Monitoring progress over time is key to seeing how well a company is performing. Startups should regularly review and adjust financial plans, forecasts, and other numbers based on any changes in their conditions. This can help ensure that the financial model remains accurate and up-to-date, and make it easier to spot potential points of improvement or areas with some financial trouble.
- Estimate sales and expenses
- Forecast cash flow
- Monitor progress
Financial Model Validation
Financial modeling is a key component of any startup business's success. Validating the financial model helps in achieving better results for long-term success. It is therefore essential to ensure the quality of the financial model before transitioning from the data gathering and modeling stages to the forecasting stage.
Compare actual results
Once the financial model is completed, the results should be tested against actual results in order to gain insight into the accuracy of the model. Comparing actual results to the model's estimates allows users to understand the margin of error and gauge the accuracy of the model. It is important to note that actual results are always updated and can improve the accuracy of the forecast if the initial assumptions were incorrect or inaccurate.
Review for accuracy
Once the model is complete and actual results have been compared, it is important to review the model for accuracy. Startups should pay careful attention to all assumptions underlying the model and remove any potential sources of inaccuracy. It is also important to check for any outliers or any logic errors in the financial model that may lead to inaccurately predicted results.
Identify data points needing improvement
Once the accuracy of the financial model has been reviewed, it is important to identify any data points that need to be improved. This is usually done by browsing through raw data and understanding its relationship with predicted results. This will help highlight potential inaccuracies or areas which need further refinement in order to ensure the accuracy of the financial model.
- Finding appropriate data sets.
- Adapting the financial model to new data points.
- Enhancing the assumptions used for the financial model.
Improving the Financial Model
As a startup business owner, improving the financial model of your company is essential for understanding the current financial standing of your startup. Your financial model should be updated routinely so you can accurately track the venture’s financial well-being. There are three main steps to consider when improving your financial model: evaluating assumptions, updating data entries, and considering scenarios.
Evaluate Assumptions
It’s important to review and evaluate the assumptions that you used to build the financial model. Ask yourself if these assumptions are still relevant and valid. For instance, if one of the assumptions was that your business will be profitable in two years, make sure you’ve considered the challenge of industry trends and competitive pressures in that two-year window. If it's not realistic, adjust the assumption[s] as needed.
Update Data Entries
Data entry is another important step for keeping your financial model up-to-date. This includes tracking revenues and expenses at a granular level, to ensure accuracy. It’s important to pay attention to the data points that are input into the model, making sure windowed sales projections, pricing points, and cost of goods are all accurate. Use actual sales data from your company’s accounting system to populate your cash flow projections.
Consider Scenarios
Another step in reviewing your financial model is to consider scenarios. Projecting hypothetical scenarios can help you understand the implications of customer volatility and seasonality trends. For instance, by varying customer rates and cutting or raising prices, you can see how it impacts the Sales, Costs, and Cash Flow of the business. Ask yourself the following questions:
- What happens if you acquire new customers, or lose existing customers?
- What are the potential impact to prices, customer loyalty and retention, or customer acquisition?
- What are the implications of competitive pressures?
- What kind of new products or services should you consider?
Conclusion
Building a financial model for a startup is a great way to help understand the current financial situation, anticipate potential strategies and investments, and identify any potential risks. When done correctly, these models can help to ensure the long-term success of a startup and help an entrepreneur plan for the future.
Re-iterate Financial Model Benefits
By creating a financial model for a startup, entrepreneurs and investors alike can better understand the current financial state of a startup as well as anticipate future investments and risks. Additionally, a financial model allows for realistic budgeting and setting of goals, which can help keep a startup on track and ensure it is reaching desired targets.
Summary of Key Points
Creating a financial model for a startup involves many factors. First and foremost, it is important to understand the metrics and data that will be used in the model and to develop an understanding of the startup’s financial state. Additionally, an understanding of the past financial performance and the long-term goals of the business should be considered to develop a model that is realistic and tailored to the specific needs of the business in question.
The model should be broken down into different parts with each segment addressing a specific goal such as revenue projections, budgeting and cost analysis, cash flow analysis, and more. Ultimately, a financial model can help entrepreneurs and investors plan for the future and make better decisions when it comes to investments and strategies for the business.
Encourage Readers to Reach Out with Questions
The process of creating a financial model for a startup may appear daunting, however it does not have to be. Taking the time to understand the metrics and key points as well as building out a model that is tailored to the specific needs of the business can help entrepreneurs and investors alike plan for the future. If you have questions or need assistance creating a financial model for a startup, please do not hesitate to reach out.