To delve into the world of financial modeling, first I would like to ask you three questions:
- Do you want to build a financially sustainable business?
- Are you planning to attract external financing?
- Do you want to avoid cash gaps and other financial problems?
If you are the founder of your own business, most likely you will answer “yes” to at least one of these questions, but quite possibly to all three. Be that as it may, the financial model will help you in the implementation of each of these tasks, and therefore, financial modeling is an important topic for you.
Goals and objectives of the financial model development
The Financial director magazine defines the goals of financial modeling in this way:
• Business evaluation.
• Raising capital.
• Business development.
• Buying a business
• Sale or disposal of assets and business units.
• Capital allocation.
• Budgeting and forecasting.
We will focus on the specifics of financial modeling in startups.
Almost all companies are engaged in financial planning and budgeting of their activities in one way or another, but there are several factors why having a financial plan is important for startups.
1. A financial plan is needed to “digitize” your business model to determine whether it has economic potential in principle.
A detailed financial forecast of income and expenses will help you ask yourself and answer a lot of questions that may get in the way of the project. The founders should be prepared to address these issues, as unresolved issues can lead to the failure of the entire project. Answers to questions when designing a financial model will help you understand whether there is a chance of success and profitability.
Next, it is important to create several scenarios for the development of events in order to plan for possible changes in the situation. For example, what happens if the product development lasts for six months? Or if the sales volume is halved? Having calculated these situations in advance, you will be able to avoid unexpected problems and become ready for changes.
2. The financial model is mandatory for attracting investments.
Investors always ask the founders for a financial plan when discussing financing, whether they are investment angels, venture funds, banks or government organizations that issue grants and subsidies. Some investors may need a deeper model than others, but developing a credible financial model will be helpful even if you need to provide them with top-level information.
Why? Because only a well-thought-out plan will allow you to answer difficult questions that an investor may have when he studies your financial forecasts. And how do you plan to attract financing if you have just come up with how much investment you really need face to face? Fundraising is a long process that can last for months. Therefore, errors in the calculation of investments can lead to cash gaps and a threat to the development of the project as a whole.
3. A financial model is needed to manage your business.
In order to understand how successfully and dynamically the project is developing, you need to prescribe indicators and come up with a plan with which you can compare the real results. And for reporting to investors, a financial model will be required, thanks to which it will be possible to calculate the funds spent, test hypotheses and verify the goals achieved.
What are the components of a startup’s financial model?
A financial model usually contains at least the following blocks:
- forward-looking financial statements (or financial plan);
- project evaluation and performance indicators;
- analysis of the break-even point and analysis of the sensitivity of the project to changes in key inputs, where possible.
And additional blocks can be: calculation of the forecast of the sales funnel, calculation of the cost of a unit of production or unit economy, and the dashboard is important, where all the main calculation indicators are displayed.
1. Financial plan
The financial plan is essentially the core of the whole model. At a minimum, it includes:
- Profit and Loss Statement (P&L)
- Cash Flow Statement (CF)
Also often, it also includes:
- Forecast balance sheet (balance sheet, or BS)
But, in my opinion, the Balance sheet in the financial model is necessary primarily for companies operating in the real sector (manufacturing, commodity business, invisibility, and so on), and is less necessary for IT startups at the first stages of their development.
P&L – Profit and Loss Statement
This report is designed to provide information about the income and expenses of your organization over a certain period of time and shows whether it will achieve profit. In addition, the report includes several key performance indicators, such as gross profit, EBITDA and net profit.
Gross profit is the difference between sales revenue and the cost of goods, works or services. And revenue, of course, is the entire amount received from sales for a certain period.
EBITDA — Earnings Before Interest, Taxes, Depreciation and Amortization — is the company’s profit before interest on loans, income tax and depreciation on fixed intangible assets. EBITDA is often referred to as operating profit and it is calculated as gross profit minus all indirect and fixed costs of the company. In fact, it shows the real profit of the company without adjustments for factors that do not relate to operating activities.
Net profit is the final financial result of the company’s activities, available to its owners after settlements on loans, deduction of depreciation and payment of taxes.
Only by building a financial model with all the relationships for your business processes, you can see how your forecast P&L changes from changes in the input data of the sales funnel, for example.
Example P&L in financial model
CASH FLOW Statement (CF)
It shows all incoming and outgoing cash flows for a certain period of time, but most importantly – accumulatively. This report will show you where cash gaps are possible. The cash gap is the state of company when there are no funds to repay the mandatory expense item.
The forecast cash flow report allows the company’s management to determine the need for external financing to prevent cash gaps, control the company’s debts, and simulate the most favorable terms of settlements with customers and suppliers.
Example CF in financial model
Balance Sheet (BS)
Balance Sheet (or Statement of Financial Position) — one of the company’s financial statements, which reflects everything that the company owns at the time of writing the report, as well as from which sources these assets were financed.
The balance sheet consists of two parts – an asset and a liability. The sum of all assets is always equal to the sum of all liabilities. The balance sheet asset displays the property and current assets owned by the company. In the liability — equity and liabilities, at the expense of which assets are created.
While the balance sheet plays a central role in accounting and financial accounting, in financial modeling it is rather an auxiliary report. Nevertheless, the inclusion of the balance sheet in the financial model helps to make it more understandable and reliable.
Often, at the start of a digital business, a company has few assets, so when modeling an IT startup, this report is not very necessary in modeling.
2. Company evaluation and performance indicators
Many startups create a financial model in order to receive investments. In order to receive investments, it is necessary to understand the growth potential and the forward-looking assessment of the company. And how to evaluate a business if it does not yet have any assets or financial flow, which is typical for a startup in the early stages? In such cases, the valuation of the company is usually carried out using the discounted cash flow method (DCF).
The advantage of the DCF method is that here the assessment is based on future results, which is ideal for startups that probably have not yet shown significant results, but have the potential for growth. The disadvantage of this method is that the evaluation result is very sensitive to the source data used for calculations. But nevertheless, this is the most common method of evaluating IT startups. Other methods of business evaluation (cost-based, comparative, and others) are not applicable in this case. DCF considers the value of a company as the sum of its future cash flows, reduced to the current value of money through a discount rate. The sum of these discounted cash flows is NPV.
Example DCF company evaluation method in financial model
NPV (Net Present Value) is the net present (to date) value of the company.
Discount rate is the interest rate used to convert future income streams into a single value of the current value. In modeling, this rate is set by an expert method, not by an exact calculation. In short, the higher the risk of the project, the higher the bet. Startups are by definition high-risk projects, and they usually apply a rate from 25% to 40% or higher.
Calculations of various performance indicators can also be included in this block. Which are important for your particular business and field of activity.
With the help of the financial model, you will be able to experiment “on paper” with various traffic channels, prices for your product and cost structure in order to formulate the main hypotheses and targets for yourself and the team and focus on them.
For example, SaaS companies usually evaluate and track, among other things, the “Lifetime Value of the customer” (Lifetime Value, or LTV), the cost of attracting customers (customer acquisition cost, or CAC), the LTV/CAC ratio and the churn rate of the user base (churn rate). Other industries will have their own specific indicators.
Break-even point analysis and sensitivity analysis of the project
In short, the calculation of the break-even point is done in two ways:
- In money. We calculate based on the input data how much money you need to get from sales to reach zero.
- In products. We find out how much goods or services need to be sold so that the company does not generate losses.
Sensitivity analysis is the identification of a “corridor” of fluctuations in key inputs, within which the business still remains viable and attractive for investment. Sensitivity analysis allows us to assess the scope of fluctuations in key parameters within which the business remains profitable for investment. This is a fundamental part of risk management and helps the owner of the company to determine the safest possible price for the product, as well as the minimum cost of attracting customers. To conduct such an analysis, it is necessary to find several key inputs and set a step to change them, and then automatically build a data table for the financial model.
To perform sensitivity analysis, it is necessary to select several pairs of the most important inputs, determine the “step” of the analysis (for example, 5%, 10%, 15%, and so on) and generate an automatic data table in the form of a matrix of values. For example, the X axis will be revenue, and the Y axis will be the cost of attracting one customer. Having built the correct relationship, we will get the values of monthly revenue for specific amounts of the cost of attracting one client, and so on.
Let’s sum up — life after the creation of a financial model
Tabular structuring of startup performance indicators allows you to determine how profitable the project will be in the long term. If the layout shows that the business will be profitable, it will indicate which target values need to be achieved in order to achieve profit. However, this is not fundamental financial analytics, but a simple model that provides basic answers.
After starting a business, new factors may appear that affect the company’s activities. In this case, the model will become biased and it will have to be edited. But if the layout was well designed with automation in mind and a deep analysis of the market, risks, etc., then the adjustment process will be fast. To do this, I try to make the model as flexible as possible to changes in input data. Input data can change constantly, but the system of interrelations of these input data with key indicators often remains unchanged. Therefore, by changing the introductory in a specially designated place for this, we can always have a model that is relevant at this stage.
Author: Roman Fisenko
Financial manager in Glocal LLC in5 Dubai incubated