Financial modeling can be understood as the art and science of budgeting and forecasting the business’s future based on financials. These are relevant for both internal budgeting and finance management, and external purposes, idea pitching during mergers, fundraising, or even exits. In this blog, let us try to understand the various segments and approaches of Financial Modeling and a few best practices to stick to.
Why Financial Modeling is important?
Financial planning and forecasting is crucial part of the startup journey. As an entrepreneur, understanding where your money is coming in and going out in various scenarios is essential for decision-making and strategic planning. It helps in quantifying and validating your business model and goals, and ultimately build a viable business. It also lets you keep a track of your financial benchmarks and inform your shareholders.
Another important requirement of these models is during the fundraising process, where you need to pitch to your potential investors to show what can be expected from your business. Such models can help you not only understand future outcomes but also figure out cost and pricing for your current products and services, that is, to budget your revenues and expenses. Especially in the case of early-stage startups, where there is no historical data to depend upon, financial models are a great way to plan operations and goals.
Approaches to forecasting
Getting the numbers is right one of the most important aspects of building a financial model, from sales projections to market sizing. There are typically two approaches to forecast such numbers:
A top-down approach, where you analyze the industry estimates globally with the help of research reports and official references as the starting point and then narrow it down to a specific target segment, fit for your business. It builds from a ‘macro’ perspective towards ‘micro’ and is more effective for long-term targets.
A bottom-up approach, where you conduct local-level primary research of potential sales with the help of recent sales history reports, customer interviews and then infer it into a national or global figure. It builds from a ‘micro’ or ‘inside-out’ perspective towards ‘macro’ and is more relevant for the short-term forecasts.
Usually, the top-down approach gives a less realistic calculations, while the bottom-up is more accurate and credible as primary analysis of market drivers, channels, customer segments, and competition, which are not considered in the former. But you can conduct both as a coherence check.
Forecasting can also be done using methods like regression analysis to determine how changes in certain assumptions or drivers of the business will impact revenue or expenses in the future, and YoY or Year-over-year growth rate expressing the rate of change over the period.
Niche models can be built with further approaches focusing on only aspects like the operating expenses or interest expense, cost projection or revenue projection based approaches, etcetera.
Before diving in…
Answer these to yourself:
Who is your audience for this model?
What are the assumptions you are looking to resolve?
If it is for a fundraising campaign, which round are you preparing for?
Is this for internal planning purposes or pitching to others?
Which approach of forecasting are you going to use?
Prospective answers to these will help you better frame the Financial Model as per specific requirements of the audience, task, and stage.
Financial model inputs
COGS or Cost of Goods Sold
These include the costs required to produce, operate, and deliver your product or service to the customers, like the direct labor, direct materials or raw materials, and overhead costs for the production. For example, cost of raw materials for a production business whereas personnel costs of staff delivering services. For a SaaS company, these could differ significantly like the cost of web hosting or web development cost. To get the final COGS, you need to identify all the underlying costs going to deliver your product or service and then multiply with the units delivered. Understanding the general COGS calculations and inventory valuations methods is important. These costs reflect in the P&L statement of a company in calculating the gross margin and also in the Balance Sheet where accounts payable and stock are mentioned.
SG&A or Sales, General, and Administrative
and OPEX or Operating Expenses
Every expense that doesn’t count under the COGS is listed under this section. Operating expenses include the costs of running the day-to-day operations of a company, even the direct costs in production, which are not a part of COGS. Some examples of operating expenses are production-related rent, salaries, business travel expenses, and so on. SG&A expenses, on the other hand, involve costs related to non-production-related operating expenses of a company like the accounting, legal, marketing expenses, rent, and utilities that are not a part of manufacturing. These are required to calculate EBITDA from revenues. As a startup, if you are not sure about which expenses you might incur in the long-term, you could take a certain percentage of your revenues as the expense categories.
Not only final revenue metrics but also financial projections are included in this section of the model. Forecasting revenue could be a tricky part but effectively using the above-discussed forecasting approaches to calculate your addressable market, and with that, the number of units that can be sold or service metrics that can be provided. Showing the drivers of such revenue and calculations behind your expected Cost of Acquisition is very important. You can learn more on making revenue calculations by different approaches like segment, store count, geography,metrics like avg. users and so on here.
Comparing your revenue with the COGS gives you the Gross Margin before accounting for the administrative expenses. Connecting the incurred expenses to this revenue is also important. It could be like a challenge to calculate the estimated costs and compare them against the actual expenses that match the estimated challenge yourself undertaken to understand where and how you’re over understating or overstating.
The best financial models work to reconcile the opposing forces, hence keeping inputs and outputs as simple as possible, while still providing sufficient details for decision-making.
CAPEX or Capital Expenditure
These are also known as investments in assets, that is, funds invested in purchasing or revamping buildings, equipment, property, both physical and intellectual. It is a significant part of the financial model which helps companies maintain existing capital assets and invest in new technology whenever necessary. These do not directly impact the income statement and profit but rather with the depreciation accumulating each year. It is directly reflected in the Balance Sheet, Assets. A company’s valuation is also impacted by the number of assets it holds, which is important in the case of liquidation.
Read more on CAPEX calculation here.
Apart from the above-discussed inputs, there are various other elements included in a Financial Model:
Assumptions and drivers behind the numbers you are using for projections. These can be any sort of built-up to validate your numbers, related to market share, or pricing, or sales.
Ascertaining startups’ valuations is necessary for making negotiations with investors during the fundraising process. This can be done using methods like DCF or Discounted Cash Flow valuation.
Explore more about it here.
Projections sheet, which includes financial forecasting of the income statement, cash flow, assets and liabilities, etcetera, based on which the statements are prepared.
Working capital, which reflects the contrast between a business’s current assets and current liabilities. In simple words, a measure of a company’s current or short-term financial efficiency, of what it owns as well as owes. It is significant in determining a company’s capability through its impact on cash flow. The calculation depends on the number of sales, outstanding payments, and holding period for inventories.
Taxes are to be deducted from income in order to ascertain the final profit. However, in case of a loss, an assessee can carry forward his/her loss to the following profitable year against the taxable income. This is why it is important to record and maintain a tax sheet in your model.
Next is the ‘Supporting schedules’. Before building the financial statements, we need to make a schedule for capital assets like Property, Plant &Equipment, along with a debt schedule for incurring debts and repayments.
Sources of financing for your business is another important input during a funding phase as it helps assess your existing capital structure. This includes its equities, debentures, leases, loans if any, and their relevant interest rates or repayment installments which in turn, affect the cash flows.
Deliverables of a Startup’s Financial Model
Following are the key elements to be delivered as a part of Financial Models:
Income Statement or Profit & Loss Statement
An Income statement shows an overview of all expenses and incomes illustrating a company's profitability. Under this, the revenue forecast is written down first, from which various expenses are forecasted and deducted.
A very important metric for investors which is, EBITDA, that is, the Earnings before Interest, Tax, Depreciation, and amortization and EBITDA margin is reflected here, and after relevant deductions from this, we arrive at the net income.
This section helps in a clear comparison of different budgets and performances of the company over different time periods.
Balance sheet is a snapshot of everything that a company owns and owes at the end of a particular reporting time period. The Assets or resources of a company' equals its Liabilities and Shareholders Equity, which is essentially the funding means for such resources. This equity represents the net value of a company, that is the difference between value of its assets and liabilities.
Comparing the asset position or debts of consecutive years or comparisons of teal earnings achieved from different assets can help in calculating several important ratios like Asset Turnover, Net Profit Margin, Return on Assets, or Return of Equities etcetera crucial for making financial decisions.
Cash Flow Statement
All the cash going in and out of a company is exhibited in the cash flow statement. It consists of three main segments namely cash from operating activities, investing activities and financing activities and combinedly these help in determining the closing cash balance at the end, which is reflected in the Balance Sheet.
To break it down, operating cash flow deals with cash changes happening in the daily course of business operations, while investing activities reflects cash inflows and outflows related to investment in external assets or shares and divesting of own assets, respectively. Financing cash flows shows the cash changes arising from activities like raising capital or paying interest to dividend-holders.
Cash flow statement is a pure reconciliation of the Year-over-year changes in the balance sheet and no item in this statement is hardcoded, rather referenced from other sections of the model. It helps the company stay in line with monitoring its daily activities relating to debt payments or investments.
KPIs (Key Performance Indicators) like gross margin, revenue growth rate, or EBIT, burn rate, LTV to CAC, breakeven, and so on should be listed in a separate sheet, which are important to both entrepreneurs and potential investors. Analyzing such metrics with the help of financial statements and presenting them in a separate sheet already makes it so much easier for viewers to understand your position. This sheet will also help you estimate the capital required to be raised for say, business growth and determine long-term and short-term performance and sustainability of your current model.
Presenting the Results
Now that you have understood the main components of the financial model, it is also important to communicate the information in a simple and easy-to-understand format. An analyst's job does not end with the preparation of a complex module but to put relevant findings from it in the form of charts, illustrations, and graphs to effectively communicate the prospective opportunities, risks and other critical factors. The presentation differs from audience-to audience such as investors, stakeholders, internal team, or strategic partners.
Best practices for Financial Modeling
Before starting, try defining:
What problem is the model intended to solve?
Who are its end users?
How will it help them?
Structure in a logical and easy-to-follow design, which is realistic as well as easy to update in the future.
Color-coding to distinguish between inputs and outputs. For example, blue color for assumptions and hard-codes, black for formulas, red for external links and references, and so on.
Simplify for reviewers as much as possible. For doing this you can,
Comment and annotate with explanations on specific workings wherever necessary
Breakdown complex calculations into simpler steps
Create a summary output sheet with key synopsis
Use excel shortcuts for faster and more efficient working. Explore some important shortcuts here.
Perform sanity checks and stress tests on your model under different scenarios to ensure that it is completely functional, using dummy data.
Assumptions are the heart of your financial model; clearly define and list the assumptions reflecting your business model. Only take assumptions that are absolutely necessary to make the model.
Explore a few Financial Models made by us down below and feel free to use them as references!
Connect us with here, if you’re looking for a professional FM done for your business now!
Remember, financial modeling is a means to gain more insights for entrepreneurs, stakeholders, and potential investors and should be a reflection of your business model, strategies, and targeted goals, focusing on the financials.