Financial modelling is the creation of startups’ financial projections for a specific timeframe. By this projection, you can find out the future growth prospects of the startups. Accordingly, it is a process of creating a summarized sheet of startups’ expenses, income and anticipating future financial decisions. Thus, financial modelling is all about understanding how a startup works in the selected period and clarifying the fund utilization.
Building a financial model or plan could be overwhelming, especially when you’re venturing out new. But your investors who expect to invest in an innovative and unique business idea would be interested to know the soundness of a startup’s financial model.
The idea of the financial model is to create a positive impact by showing some credible information in numbers which the new venture can achieve. Investors usually put considerable time into validating the numbers presented because the soundness of the numbers and the logic behind the same is the way to identify whether it is worth investing in. Further, With a suitable financial model, investors will evaluate the potential value of a business idea and how well they can compete with similar industries.
Creating a financial model is entirely dependent on the nature of the startups. Each startup will have a different flavour and hence another way to represent its financial model contemplations. Financial Modeling is the core element to make vital financial decisions in a corporate world. This guide takes you through all the tiny details of getting to your perfect financial model.
Financial models pave the way to make better financial decisions. The following are the major applications of financial modelling;
Preparing the financial model has a variety of reasons. The following pointers help you to understand the users and their need for financial models;
A financial model is a significant aspect for every company/startup. Building such models in excel is not an iterative process. They are prone to errors if not scrutinized or paid attention thoroughly. There are many details and features to be considered to create a crystal transparent model. The following best practices would help you to build sound financial models-
Financial modeling is a big help to solve financial problems in the real world. Many startups depend on financial models for making effective financial decisions. Further, it helps investors to choose which startups are worth their time and money. A good financial model for startups carter the following benefits :
To understand the functioning of any business, it is crucial to conduct variance analysis/Performance review for most startups. A solid financial model helps startups review performance by comparing actual results against expected ones. Further, it also determines deviations based on the variance analysis and the ways for eliminating them.
Using financial models, startups can determine true net worth and the exact amount of free cash flows at different time points, which further helps in the valuation (fair value) of a startup much more effortlessly.
Generally, startups may take several months to get answers for specific financial decisions. However, using financial modeling, experts can determine immediate financial impacts and outputs.
Financial models allow startups to build budgets and forecasts for a definite period based on industry dynamics, market trends, and business data.
Cash flow requirements can give an idea of how much money is needed on hand to survive and compete with similar industries. Financial models provide a clear understanding of the cash flow situation, making it easier for startups to decide on their funding strategies.
Financial modeling performs due diligence by suggesting possible risk factors in particular business activities.
For example- A financial model can guide the price changes, marketing effects, cost of entrance if a startup likes to enter the new market for the first time.
The preparation of financial models is a complex task performed in a proper sequential manner with appropriate steps. Following are the typical steps to be followed to prepare engaging and professional financial models.
Understanding your industry is an important step that has to be considered while building financial models. There are many open sources to get information about the industry and the companies in that segment, like company websites, published annual reports, and even the regulatory body.
For example, If you want basic information about a company in India, it will be readily available on the Ministry of Corporate Affairs (MCA) website.
In-depth market research is to be done to identify the growth potential of your segment. Consider industry analysis reports to understand the industry dynamics of the particular company. These reports give you an insight into the decision to kick start your venture according to the market trend.
Suppose if a person chooses to put up FMCG products as his business. He must look up the consumer industry thoroughly then dig down the subset of sectors such as competitor’s details, the present market players in the industry, and so on. When all this information is sorted out, he will have a detailed understanding of this industry’s plans to catch the market with very baseline progress.
By listing out the company into a similar line, you have to validate the audited numbers of the particular companies. Then, insert audited numbers in excel sheets in a proper format. Audited numbers are incorporated for 3-5 years for better growth projections.
The next step is to calculate assumptions by computing the previous ratio like Revenue Growth, Expenses to a percentage, Gross Profit Margin, EBITDA Margin, and Working Capital. Assumptions should be created in a separate tab for revenue, COGS, employee headcounts, capital expenditure, and much more. Additionally, forecast similar ratios for future years to ascertain the forecasted numbers.
For example, if your company has obtained growth by a Revenue CAGR (Compounded Annual Growth Rate) of 20% for the last three years, the industry is likewise growing by a similar rate for future years. Then, at that point, you can again expect a similar growth pace of revenue for the next 2-3 years.
After finding the correct assumptions, start calculating all the forecasted numbers of Statement of Profit & Loss (P&L) from top to down until all the expenses except Depreciation, Finance cost (Interest), and Income tax. By this stage, you will get the forecasted EBITDA on the sheet. If you have initial rounds of conversations with the investors regarding fundraising, then projected numbers until EBITDA can give him clarity. Later you can discuss your business in detail.
Before building the balance sheet, the next step is to prepare supporting schedules for the balance sheet, such as;
Use the supporting schedule to prepare the projection of the income statement and Balance sheet. Do remember to link subsequent schedules with the Balance sheet (except for cash and bank balances because it is calculated after completing the Cash Flow Statement).
This is a simple step in the overall financial modeling process. Once the income statement and the balance sheet are ready, the only task is to incorporate formulas and link them with the Income statement and Balance sheet for cash flow completion. Cash flow statements give the cash and cash equivalents balance at the end of the year, which are connected to the Balance sheet’s cash balance, and three model financial statements will be ready to present.
The next step is to prepare the Free Cash Flows after completing the three-statement model. Free cash flow is the cash available for the company after clearing all internal and external obligations. It would be best to calculate Free Cash Flows to the firm and Free Cash Flows to Equity from the last calculated numbers from 3 statements (Balance sheet, Income statement, Cash Flow statement).
The next step is to calculate the Cost of Equity through CAPM (Capital Assets Pricing Model) using the Market Rate of Return, Risk-Free Rate, and Beta value. Further, computation of the Cost of Debt using Interest Rate and tax rate helps calculate the Weighted Average Cost of Capital (WACC), and this is used as the present value rate to calculate the current value of future projected free cash flows.
Performing ratio analysis is the final step in financial modeling. Ratio analysis is done by estimating profitability, solvency, and liquidity ratios for investors to make better investment decisions.
For example; In your ratio analysis, you can calculate ratios such as the Return on Equity, the Return on the Capital employed, and the Return on Assets to high point the company’s profitability to investors
The elements of financial modeling are closely dependent on one another. So giving equal consideration to individual components helps to gain better financial outcomes. The following are some of the elements considered while building a better financial model.
An effective financial model should have reasonable assumptions because they drive projections of a startup. So, assumptions need to be realistic and almost appropriate.
The income statement is one of the essential elements in the financial modeling process. It is like the lifeblood of the entire financial modeling process. As a result, you will have to determine the business connections to EBITDA (Earnings Before Interest, Depreciation, and Amortization).
The balance sheet shows the financial position of a startup at the end of the reporting period or annually. The balance sheet displays the startup’s items assets, liabilities, equity, and shareholder’s fund. Mainly, the balance sheet is prepared by assuming the operation you did in the income statement.
A Cash flow statement helps determine a startup’s cash and bank balance at the end of the reported year. Therefore, the compensation which came in the cash flow statement will be shown in the balance sheet.
A supporting schedule breaks down the core statement into more minor schedules and manages the calculations outside of the core statements. Here it allows the focus to remain on the core statements, which will be neat. In a horizontal model, these supporting schedules are placed on separate tabs from the core statements.
A tool used in the financial model to analyze how different independent variables affect a specific dependent variable under a particular condition. This tool is said to be sensitivity analysis. For example, if a financial analyst wants to determine the effect of a company’s networking capital on its profit margin, he will use sensitivity analysis. The analysis will include all the variables that impact the company’s profit margin, such as the Cost of Goods Sold, workers’ and managers’s salaries. The analysis will divide each of these variables and fixed costs and record all the likely outcomes.
Every startup needs to know specific financial metrics to track its financial performance and build a strong foundation. Financial metrics can change when your startup decides to raise funds, measure KPI, and plan for the future. The more you know your startup’s financial metrics, the better experience you can create for the investors. So, new entrepreneurs should understand the following key financials and analytical metrics.
Revenue is the total amount of money that a startup earns by selling its products/services. Since revenue does not take into account business expenses in most cases, it cannot be considered as an exact measure of a startup’s financial performance. But still, overall revenue can give a picture of the startup in a small line.
Monthly Recurring Revenue (MRR) is a financial metric for Saas startups or any type of subscription-based platform. MRR is the recurring revenue earned from subscription customers. The advantage of the MRR is that it makes the revenue more predictable than one-time sales. Therefore, when a startup builds a model, it can represent potential growth, a factor in churn, and different aspects of your business.
When a startup loses monthly recurring revenue from existing customers, then it is termed MRR churn or revenue churn. Mostly MRR churn happens when the customers cancel their subscription or when they downgrade their account. If the MRR churn is continuously growing, it means the startup fails to retain its customer. It is one of the important financial metrics for startups to identify negative trends earlier.
Return on Investment (ROI) is a measurement to ascertain the gains or losses suffered from an investment. To compute your ROI in a new venture or project, divide your profits or losses by your entire investment and multiply the outcome by 100 to get the ROI in percent.
As a startup, one may completely ignore the money you spent to make it happen. Gross margin is the total income left after factoring in the Cost of Goods Sold (COGS). When calculating gross margin, pay attention to the ratio of revenue to COGS. However, it gives a true picture of how much revenue a startup is actually generating.
Customer LTV is one of the most important financial metrics for a startup with a recurring financial model. The revenue generated for a startup by customers over the lifetime of their membership is called LTV. Most startups track LTC to know how much they can afford to spend to acquire customers. It provides information regarding the average revenue amount and average subscription length for customers.
Customers play a vital role in every startup to increase its growth. An average amount of money needs to be put in position for acquiring new customers, which is termed as Customer Acquisition Cost. The cost associated with acquiring new customers includes advertising, sales and marketing software, marketing material and employee salaries. CAC can either make or break a startup. If money is consumed too much, it will generate new customers, but gradually it leads to a shortage of funds. On the other hand, spending less will not maximize the gaining of new customers. Basically, it is to find that sweet spot you spend sufficiently enough to make money and acquire high-quality customers.
There will be a sensible amount of money which is spent to acquire new customers towards the business. The period taken to recover the cost for acquiring the customers is termed the CAC payback period. On other aspects, it’s time to achieve break-even. A startup makes money from newly acquired customers if the CAC payback period is shorter. If not, then it eventually takes a good time to be at break-even.
Cash runway is the period of time that a startup has before it runs out of money. The more extended your runway, the more time you need to build and develop your startup. A startup’s runway is determined by its revenue and expenses. This means if your monthly revenues are less than that of your monthly expenses, then obviously, your startup will be out of cash. A smaller runaway means the startup is either spending too much money or their revenue is not growing at a sustainable rate. A startup can extend the period of runaway by reducing expenses, increasing revenue, or getting more funds from investors. Thus, Tracking runaways helps to forecast financial issues before things get out of control.
Burn rate has a close relation with cash run away. One can’t calculate the runaway without knowing the burn rate. Burn rate means the money which a company loses per month. The burn rate is not a bad thing since it is necessary to build a startup. The problem comes with you spending too much money. In such a situation, the startup must cautiously check the most oversized expenses and see where the cost can be reduced.
The most common financial modeling are listed below;
Three statement model is the most basic type of financial modeling. In this model, the three financial statements, such as Income statement, Balance sheet, and Cash flow statement, are linked with formulas in Excel. Additionally, assumptions are made to drive changes in the entire model, and three statements are connected. This model is like a base for additional basic models like DCF valuation, merger and acquisition models, and so on.
Discounted cash flow is one of the valuation methods used to evaluate the worth of an investment based on its calculated future cash flows. The DCF method is a robust and widely accepted valuation tool because it concentrates on the cash generation of future business potential. Thus, DCF valuation helps figure out the value of an asset today, based on the money generated in the future.
A merger is the “blend” of two organizations to frame one entity under a common understanding. An acquisition happens when one organization proposes to offer money or its offers to gain another organization. In the two cases, the two organizations merge to form one organization, subject to the endorsement of the investors of the two organizations. A merger model is an analysis addressing the merger of two organizations that meet up through an M&A process. It is the most common model used in investment banking and corporate development.
When a private company becomes public whose offers are exchanged on a stock trade, it is an Initial Public Offering (IPO). This process is often known as “going public.” Investment bankers and corporate development commonly use this model to value their company before going public. It also sets assumptions regarding how much investors will be willing to pay for the company.
A leveraged buyout is a transaction that occurs when a private equity firm borrows from a variety of lenders and funds the balance with their equity. In an LBO, the objective of the investing company or buyer is to make significant yields on their equity investment, utilizing debt to build the expected returns. This transaction requires financial modeling with debt schedules and is the most advanced and challenging type of financial modeling.
A Consolidation Model is a kind of reporting model category of financial models. This model combines several business units into a single model for financial modeling and analysis.
The SOTP model belongs to the valuation category of financial modeling. This model takes into account multiple DCF models and adds them together. Further, any sundry business factors that might not be suitable for a DCF analysis are added to that value of the business.
Professionals use a budget model in financial planning and analysis to get budgets for the next few years, say one, three, or five years. This model belongs to the reporting model category of financial models. It coordinates actual future performance to an ideal situation that incorporates its best sales estimates, costs, asset replacements, cash flows, and other components.
Like the Budget model, the Forecast model is also used in financial planning and analysis to build a forecast that compares to the budget model.
How should you optimize your research for the best model?
Market research refers to conducting a detailed study to discover the target market, potential demand, the validity of new product/service or upgrade existing products/services. It involves both primary and secondary data to build the best financial models. The primary research includes the following:-
Building a financial model is not an easy task done in a short period. It requires a considerable amount of research and logical reasoning abilities to get almost an accurate result. Usually, financial modeling is made by financial consultants or any person who is involved in financial decision-making. In general, many companies have in-house financial analysts to prepare their financial models. Some companies do not prefer outsourcing financial models to other consultants as it contains a high level of confidentiality and sensitive information. A person with a finance background can build financial modeling. He should have strong excel skills, logical problem-solving skills, and thorough knowledge of accounting principles and treatments to make the same. Further, he is responsible for researching recent changes, trends, and risk elements in the prevailing market.
When an investor gives capital, he’s not just investing money in your company but is also making investments. So, It is essential to build strong financial models to show how fantastic it is to invest in the company. The financial model is considered a valuable tool that understands the internal company decision-making. Anybody can write down a couple of projections and consider it a financial model. But, an investor genuinely needs to know how much money a business can make within a definite period. Investors look forward to understanding how your company will utilize its cash and how long your burn rate or cash runaway will be.
New entrepreneurs should convince investors that they’re selling a unique product/service that a market demands. Further, they would like to know whether you can highlight Key Performance Indicators (KPI) and develop a solid revenue model that can stimulate higher business growth in the future. An investor loses interest if he fails to understand the numbers that drive your projections. So, impress them by developing a solid financial model that demonstrates what resources you need and when to execute on that model.
The basic financials – income statement, cash flow statement, and balance sheet- give a startup an in-depth study. The startup’s financial aspect provides the investor with an idea about how the startup will gain market presents in the future and how long the burn rate or cash runaway will be. To create a pitch deck, solid numbers are required to get the attention of the investors that you’re approaching. Even though it doesn’t matter how great your business ideas and market research are, your pitch deck will probably fail if you don’t have convincing financials. Thus, it is essential to add financials to the pitch deck.
Financials are essential to convince investors how well the startup will generate profit and utilize the resources in monetary terms. A financial plan shows all possible growth of a particular business using numbers. It is brought down into small steps to use a startup’s assets and liabilities, thereby understanding the profit based on the reasonable financial forecast. Usually, it is created by putting together all the business components and representing them with the help of numbers that includes the revenue and preliminary expenses of a company.
A business plan is a written document that aggregates all the minute details involved in the startup. It describes both the operational and financial objectives of a startup. A business plan gives an insight into business strategies, goals, and the resources for achieving the same. It can lead the organization to gain funding from an investor or bring a new business partner. The plan has to be specified in a way that it has to meet the business needs.
The financial part of your business plan gives an idea of whether it will flourish or not. It will focus on the investors who are interested in your innovative business ideas. By preparing financial statements in a business plan, the startup can identify the dos and dont’s with the funds they have or funds yet to get.
The financial section contains three different statements;
A financial analyst should follow specific disciplines to build a robust financial model without mistakes or errors that one is prone to make. Listed below are the ways to prevent financial failure using a good model;
Financial modeling helps forecast a startup’s future revenue, performance, and financial results for a specific period. It requires a high level of financial literacy, logical thinking, and a solid foundation in Excel to develop robust financial models. An inexperienced user finds it difficult and consumes more time to build the same. So before stepping out to forecast, it’s essential to learn how to create an effective model. Let’s discuss a few ways to know them;
Before moving to build a startup’s financial model, it’s important to understand the information which serves as the input sheets of a model. Let’s discuss one-by-one in brief:
The first and foremost information one should have before building a model is revenue forecast. Most startups complain that forecasting the revenues takes a lot of time because they haven’t achieved sales in the past. Revenue is forecasted using 2 common methods- Top down method (long term sales forecast) and Bottom up method (short term sales forecast).
COGS is the cost incurred when a startup delivers a product/service. COGS may differ based on the type of product/service a particular startup sells. For instance, a startup selling products should include the cost of materials used to create products whereas in case of consultancy services should include personnel cost of employees providing the service.
Operating expenses are expenses that a startup incurs to run/perform its normal operations.Office supplies, traveling costs, payroll costs, patent costs, IT costs, legal costs are some of the examples of operating expenses.
Employee’s details are significant to build an effective model. Employee forecast includes projecting number of employees hired, their salaries, additional benefits and so on.
Capital expenditures are expenses incurred by a startup to upgrade or acquire physical assets such as Intellectual Property (IP), physical property, buildings or equipments.These expenditures will differ according to the nature and type of startups. As a new venture, it is common to invest in softwares, computers, machinery, and office equipment.
Collect information relating to financing streams such as equity, loans or subsidies. Adding funding information helps to check the impact on your funding needs.
The difference between current assets and current liabilities constitute the amount of working capital. Current assets include cash , inventory, and accounts receivables and Current liabilities include wages, interest owned, taxes, and accounts payable.
Depreciation is reduction in the value of assets over time due to inefficiency/obsolescence, wear and tear and so on. It is part of the profit and loss statement and also impacts assets value in the balance sheet.
Most startups fail to raise funds from investors because new entrepreneurs don’t know how to execute the right numbers in financial models to validate that they are worth investing. Further, they are destined to struggle without proper market research, financial plan, business model and so on.
Scaalex is a team of highly driven domain experts and financial consultants. We closely worked with 270+ startups to build the financial projections, valuation report, business plan, and funding advisory. We stand for an expert team in-depth market search and also understand the expectations of new entrepreneurs. If you are one among the startups who lack adequate financial insights, reach out to us to attain exceptional execution and fundraising results!
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