What exactly is financial modeling for startups? Well, it is the process of projecting and forecasting revenue, employees, customers, expenses, etc., for the future to understand and assess the viability and profitability of the business. As the startup is still in its infancy, this modeling will help them create their budget and business plan. It will help present the business plan to potential investors.
Through this post, we wish to explain: What is Financial Modeling for Startups? It’s important, and you can start implementing it in your own business.
Business decisions based on data
You know that business decisions need to be driven by data. Usually, the best financial leaders analyze where their business needs to go and what is needed to be done to get there. We know that it is easier said than done, of course.
Startup businesses can have jagged growth patterns initially. That is not unusual. It happens due to their large influxes of external funding and development of unique products. It’s not always a simple thing to handle their cash flows and revenue growth over time.
Luckily, there are several powerful strategies you can use to help leverage your financial data. They are financial modeling, forecasting, and budgeting.
A financial model is a tool that entrepreneurs utilize to represent the entirety of a startup’s historical and future performance. Here, future performance is analyzed based on a set of assumptions. Transactional impacts are represented in numerous accounts. Therefore, it is possible to alter one and then see how that change impacts the other.
Once you build the model, you can manipulate it using forecasting techniques. These techniques include forecasting and budgeting to provide insight into the growth of the business. Often, entrepreneurs use different office packages (Google Sheets, Microsoft Excel, LibreOffice, etc.) to construct financial models. Keep in mind that the most fundamental form of a financial model is the three-statement statement model. This includes an interconnected balance sheet, cash flow statement, and income statement.
Why is financial modeling for a startup important?
A Financial model can be a powerful tool for several reasons. There is one very important thing that stands out. That is, they enable your business to make effective financial decisions.
So, what if you go ahead without an in-depth financial model? If you do so, your startup’s ability to plan for the future could be incredibly limited. Businesses that make decisions without properly considering the impact they’ll have on their finances are at a huge risk. It is more likely that they run into cash flow issues. They would often spend too much money or in the wrong places.
Benefits of financial models
A financial model allows you to test several scenarios for the future, focus on the potential results, and come up with strategic decisions based on that information.
- It helps in understanding the revenue and cash flow forecast for the business.
- It helps in figuring out the business’s assumptions while creating the startup.
- Usually, investors carefully look through the financial model before deciding to invest in a business.
- It helps in understanding the profitability and viability of the startup.
- It helps in showcasing the real picture of your business to the external investor and debating the investment terms.
- It helps in quantifying the assumptions for the startup business.
Now that we know the importance of a financial model, we can move on to look at how you would build one for your startup.
Top – Down Approach
First up, we have the top-down approach. In the top-down approach, you start with macro factors and gradually work through the micro factors. Starting points are the industry standards, which essentially narrow down the goals the business can fit into. This particular approach assists with defining the forecast based on the market share you wish to acquire.
The TAM (total available market), SAM (serviceable available market), and SOM (serviceable obtainable market) models help in this type of approach. The TAM for the product is estimated as the first step in this model. After that, you have to figure out which part of the market you want to acquire, which is called the SAM. From that SAM, the current service base of the company is known as SOM based on the existing competition. So, in this model, you start out with the size of the industry and the market share you can capture.
Bottom – Up Approach
The method that is used in the bottom-up analysis is fundamentally different. An individual stock’s characteristics and micro-attributes are the prime targets of the bottom-up method. Bottom-up investment focuses on the underlying strengths of individual companies or industries. This study looks to find lucrative openings by comparing the unique qualities of a firm with its market value.
Research for bottom-up investment starts at the company level but continues upstream. The fundamentals of the company are taken into consideration, and the industry and local economy are also taken into account. Therefore, the bottom-up investment might be quite broad throughout an entire sector or extremely narrow in finding crucial characteristics.
How to Build a Financial Model
Here’s what you have to do to build a financial model:
- Compile your business’s previous financial statements.
- Calculate the annual trends and make your assumptions for future changes in revenue growth rate, gross profit margins, fixed costs, and variable costs.
- Use them to come up with future income statements from revenue down to earnings before interest, taxes, depreciation, and amortization (EBITDA).
- Start by building the balance sheet first with your prior balance sheet and adjusting it using your income statement activity.
- Prepare a supporting schedule for your capital assets, interest, and debt.
- Utilize that schedule to fill in interest on the income statement. Once that’s done, calculate your net income and taxes.
- Estimate your closing capital assets, debt, and equity balances using the schedules and net income for the year.
- Create a cash flow statement, working backward from your net income (adjusting for non-cash expenses).
Financial modeling and forecasting are essentially linked. That is why they tend to get confused with one another. However, the distinction is that the model is the tool. On the other hand, forecasting is its primary purpose.
Forecasting refers to the use of pivotal assumptions about the future and historical data to predict your startup’s future performance.
This may surprise you, but the key to creating the most effective forecast often lies more in assumptions of the model than anything else. That’s right. Remember that these assumptions can swing the projected results wildly. They have the potential to make or break the forecast. That is why you have to take forecasting seriously. As an entrepreneur, you need to be able to effectively forecast your business’s future. For that, you should have a deep understanding of your startup’s business model, your market, your competition, and all the other external factors that might affect your growth.
The Importance of Forecasting
Forecasting is the biggest reason that financial models are built. As you know, a financial model can provide a framework for understanding your business. However, they would not mean anything unless you used them to plan for the future. Forecasting effectively allows a startup to:
Time your decisions properly
As you know, startups need to hire employees, buy equipment, and pursue rounds of funding to grow their business effectively, but they have to time each of these very carefully. Going ahead without funding for too long, hiring employees too early, or purchasing expensive equipment at the wrong time might carry your company to bankruptcy. Forecasting allows you to predict when your startup will be ready for big investments and when it will need new funding, so you can prepare well.
Pivot quickly in bad scenarios
All startup businesses should be able to forecast good, average, and poor scenarios for the future. This helps them come up with plans for each of those. You can stop being blindsided by outcomes that are less than you hoped for and respond to them instantly by using forecasting to create a contingency plan ahead of time.
Optimize its resource allocation
Startups have limited labor hours and funds. That is why they have to utilize them both cautiously. This is where forecasting comes in handy. Forecasting allows you to figure out the most essential levers driving your company’s growth, so you get the chance to invest your resources where they matter most.
Budgeting is essentially a subset of forecasting that is very much focused on costs and other cash outflows. This is a common way of utilizing the three-statement model, although it depends more on the income statement than anything else.
You’ll need to create different budgets for your business at each stage of its growth. For instance, you will need to create a budget for the costs of getting your product or service ready for sale before you start bringing in any revenue. But when you bring in revenue, your operations will, of course, expand. Then you’ll have to refine your budget by considering these new expenses.
So why should you budget? Well, budgeting is such an important element for a startup business at any stage. We cannot stress that enough. But it’s especially needed for businesses that are concerned with their cash flow. This can be during times of low revenues or thin margins.
Once your startup business evolves past such challenges, your budget becomes a more analytical tool. Monthly or quarterly meetings are common for effective finance teams to review actual expenditures vs. planned expenditures. Thus, they are able to identify problems within different areas and make necessary adjustments.
How to build a startup budget
Here’s what you have to do when building a startup budget:
1. Figure out your fixed costs
These will be hard to cut back on and include expenses such as payroll, rent, and insurance.
2. Estimate your variable costs
These will scale up with your sales and include expenses such as raw materials, shipping costs, and utilities.
3. Estimate your monthly revenue
Before anything, here is a heads-up: this step can be difficult. However, your revenues will be the benchmark against which to gauge your expenses.
4. Add in a healthy margin
Every business needs to have a buffer, just to be cautious.
- Figure out your expenses by dividing them into necessary and discretionary categories.
- Determine where you can make reductions in spending.
- Adjusting, however, is needed.
- Make sure to minimize discretionary costs to get your expenses under revenues with a healthy margin included.
- Compare your budgeted outcomes to your actual results as frequently as possible. It would be best if you did so every month.
You had the opportunity to get knowledge about “What Is Financial Modeling for Startups?” You learned about types of financial modeling, forecasting, and budgeting as well. The information we presented will surely help you build your startup business. You will also benefit from reading our post: How to Boost Productivity of Your Startup.