Understanding Financial Modeling: What it is and Why it matters for Startups
A financial model is a tool used to forecast a company’s financial performance based on a set of assumptions.
Financial models are typically built using spreadsheet software and incorporate a range of financial and operational data, including revenue projections, expense forecasts, capital expenditure plans, and cash flow projections. They can be used for a variety of purposes, including budgeting and planning, valuation analysis, and decision-making. Financial models provide a framework for understanding the financial implications of various scenarios and help businesses make informed decisions about how to allocate resources, prioritize initiatives, and achieve their financial goals.
The Three-Statement Financial Model
A financial model typically includes the three main financial statements: the income statement, balance sheet, and cash flow statement:
The income statement, also known as the profit and loss statement, shows the company’s revenues, expenses, and net income over a specific period. The income statement is used to assess the company’s profitability and overall financial performance.
The balance sheet provides a snapshot of the company’s financial position at a specific point in time, and shows its assets, liabilities, and equity. The balance sheet is used to assess the company’s financial health and its ability to meet its financial obligations.
Cash flow statement
The cash flow statement shows the cash inflows and outflows for the company over a specific period. It is used to assess the company’s ability to generate cash, manage its cash flow, and fund its operations and growth.
Together, these three statements provide a comprehensive view of the company’s financial performance, financial position, and cash flows.
Why Financial Modeling is crucial for Startups?
Financial modeling is particularly important for early-stage startups because it helps them to understand the financial implications of their business plans and make informed decisions about how to allocate their resources.
Without a financial model, startups may be operating blindly, relying on guesswork or intuition to guide their decisions, which can be risky and lead to poor outcomes.
Here are a few specific reasons why financial modeling is important for early-stage startups:
Helps with fundraising
: Early-stage startups often need to raise capital from investors, and having a solid financial model can help demonstrate the potential return on investment and build investor confidence in the business.
Supports strategic planning: Financial models can be used to explore different scenarios and test the impact of different assumptions, allowing startups to make more informed decisions about their strategy and priorities.
Helps manage cash flow: Cash flow is critical for startups, and financial models can help to forecast cash flow needs and identify potential cash flow gaps before they occur.
Enables financial discipline: By building and maintaining a financial model, startups can develop financial discipline and rigor, which can help to ensure that they are making sound financial decisions and operating in a financially sustainable manner.
Beyond the Bottom Line: Is Financial Modeling for Impact businesses any different?
A financial model for an impact or climate-tech business may differ from that of a traditional business in several ways.
Firstly, impact and climate-tech businesses often have a “double bottom line” or “triple bottom line” approach to measuring success
. In addition to financial metrics such as revenue, profit, and cash flow, they may also measure social or environmental impact. Therefore, a financial model for such businesses may need to incorporate these additional metrics to accurately reflect the company’s performance.
Secondly, impact and climate-tech businesses may have unique revenue streams, cost structures, and cash flow dynamics compared to traditional businesses. For example, a business that sells carbon credits or provides sustainable energy solutions may have revenue that is dependent on government policies or subsidies. Understanding these nuances and incorporating them into the financial model is crucial for accurate forecasting and decision-making.
Lastly, impact and climate-tech businesses may have a longer timeline to profitability or exit compared to traditional businesses. This is because they may be working on solutions that require significant upfront investment or have longer adoption cycles. As a result, the financial model may need to account for a longer runway and potentially a larger investment requirement.
The Process of Building a Financial Model
Building a financial model for an impact startup can be a daunting task.
To create an accurate financial model, you’ll need to set clear goals and KPIs, understand your business model and make key assumptions based on historical data and industry benchmarks and then test different scenarios to ensure the model is accurate and reliable.
Let’s take a closer look:
The first step in building a financial model is to set clear goals for the model. This involves defining the purpose of the model, the time period it will cover (usually 3 to 5 years), and the types of analysis that will be performed. For example, a startup may want to create a financial model to forecast revenue and expenses over the next 3 years, or to evaluate the financial impact of different growth strategies.
Once the goals have been established, it’s important to identify the key performance indicators (KPIs) that will be tracked and measured in the financial model. KPIs are metrics that help to evaluate the success of the business and inform strategic decision-making. Common KPIs for startups include revenue growth, customer acquisition costs, and churn rate.
Historical financial data is used to establish a baseline for the financial model, ensuring its accuracy. In case a company does not have historical financial data – as is the case of very early stage, pre-revenue startups – it’s still possible to create a financial model by making assumptions based on industry benchmarks, market research, and the company’s business plan. In such cases, it’s important to be conservative in making assumptions, to test them thoroughly, and to monitor the model’s performance regularly. As the company grows and generates more data, the financial model can be refined and adjusted accordingly.
Financial models are built using assumptions about the future performance of the business. These assumptions can include revenue growth rates, pricing strategies, operating expenses, and other key drivers of financial performance. Base your assumptions on historical data, industry benchmarks and a thorough market research in order to make proper projections of future performance. For example, you might research trends in your industry, the competitive landscape, or consumer behavior to inform your assumptions about sales growth or pricing.
Among others, these are some of the key assumptions that you will have to include in your financial model:
Revenue growth: One of the most critical assumptions in a financial model is the rate at which the company’s revenue will grow over time. This can be based on factors such as market size, customer acquisition, and pricing.
Operating expenses (OPEX): these should include all of the costs associated with running your business, including salaries, rent, utilities, marketing expenses, and other operational costs.
Capital expenditures (CAPEX): these include investments in long-term assets such as equipment, software, or real estate. These expenditures can be significant for startups, so it’s important to make realistic assumptions about the timing and cost of these investments.
Create your financial statements
Once you have identified your assumptions, you can begin building your financial statements, including an income statement, balance sheet, and cash flow statement.
Financial models should include multiple scenarios that reflect different potential outcomes for the business. For example, a startup might create a base case scenario, an optimistic scenario, and a pessimistic scenario. This allows the entrepreneur to evaluate the potential financial impact of different business decisions and external factors, such as changes in the market or unexpected expenses.
Reviewing and Refining
Once you have built your financial model, you should review it carefully to ensure that it accurately reflects your business plan and projections. This may involve testing the sensitivity of the model to different scenarios, benchmarking the model against industry standards or similar companies, and examining the consistency and reliability of the inputs and assumptions.
It’s important to note that reviewing and refining a financial model is an ongoing process that should be revisited periodically as the business evolves.
This may involve updating the assumptions and projections as new data becomes available, and ensuring that the model remains relevant and useful to the business over time.
Where to start with your Financial Model?
Before starting to build a financial model, it’s important to choose the right tool for the job. There are several options available for building financial models, being the most common ones Excel templates and specialized software.
Excel templates are a popular choice for startups because they are easy to use and widely available. There are many free and paid templates available online that can be customized to meet the needs of the business. Excel templates can be a good choice for simpler financial models, but they may not be suitable for more complex models that require advanced calculations or data analysis.
Specialized financial modeling software is another option for startups. These tools are designed specifically for building financial models and can offer more advanced features, such as scenario analysis and sensitivity testing. However, they can be more expensive and may require some training to use effectively.
DIY vs Professional Financial Modeling: Which is Right for Your Startup?
There are pros and cons to both DIY financial modeling and hiring a professional to build a financial model for your startup.
DIY Financial Modeling can be a cost-effective option for startups with limited resources. With the right tools and resources, founders can create a basic financial model that can be used to inform business decisions. DIY financial modeling can also provide a deeper understanding of the financials and assumptions behind the model, which can be valuable for founders looking to stay closely involved in the financial management of their business.
However, there are also some drawbacks to DIY financial modeling. First, it can be time-consuming to create a comprehensive and accurate financial model, especially for founders who are not familiar with financial modeling best practices. Additionally, DIY models may lack the sophistication and complexity of models built by professional financial analysts, which could limit their usefulness for complex financial decisions.
Hiring a Professional to build a financial model for your startup can provide a higher level of accuracy, sophistication, and customization than a DIY model. Professional financial analysts have the expertise and tools to create detailed financial models that can be used to inform complex business decisions. They can also provide valuable insights and recommendations based on their experience working with similar companies and industries. Furthermore, having a professional proof-checking your model, will provide you an objective perspective and identify potential errors or issues that may have been missed.
However, there are also some drawbacks to hiring a professional. First, it can be costly, especially for startups with limited resources. Additionally, founders may be less involved in the financial modeling process, which could limit their understanding of the underlying assumptions and financials.
In the context of Fundraising, Financial modeling is a fundamental tool because it helps startups determine their funding needs and present a clear and compelling case to potential investors.
A well-built financial model can help identify the amount of funding needed, the timing of that funding and the expected return on investment
. By presenting investors with a solid financial plan, startups can increase their chances of securing funding
and achieving their goals.
While it is possible to create a model on your own, seeking the help of a professional financial analyst can save you time, ensure accuracy, give you peace of mind and confidence in your projections, helping you make more informed business decisions.
If you need assistance building a financial model for your startup, don’t hesitate to reach out to us for help.