The most fundamental form of a financial model is the Three Statement Model, which includes an interconnected balance sheet, income statement and cash flow statement.
It’s a necessary base for the creation of more complicated models, like the Discounted Cash Flow (DCF) Model which can be used to value your company for a potential investor.
The Importance of Financial Modeling
Financial models are a powerful tool for many reasons, but the most important by far is that they enable your business to make exponentially more effective financial decisions.
Without an in-depth financial model, your startup’s ability to plan for the future is extremely limited. Businesses that make decisions without an accurate understanding of what impact they’ll have on their financials are asking for trouble. They’ll very quickly run into cash flow problems, often spending too much or in the wrong places.
A financial model allows you to test multiple scenarios of the future, analyze the potential outcomes and make strategic decisions using that information.
Now, let’s take a quick look at how you would build a financial model for your startup.
How to Build a Financial Model
- Compile your company’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.
- Begin building the balance sheet starting with your prior balance sheet and adjusting it using your income statement activity.
- Create a supporting schedule for your capital assets, debt and interest.
- Use that schedule to fill in depreciation and interest on the income statement, then calculate your taxes and net income.
- Calculate your closing capital assets, debt and equity balances using the schedules and net income for the year.
- Build the cash flow statement, working backward from your net income (adjusting for non-cash expenses).
Financial modeling and forecasting are intimately linked and often confused for one another. But here’s the distinction: the model is the tool, while forecasting is its primary purpose.
Forecasting is the use of historical data and pivotal assumptions about the future to predict your business’s future performance.
Surprisingly, the key to creating an effective forecast often lies more in the assumptions than anything else. Those assumptions can swing the projected results wildly and are usually what make or break the forecast.
To effectively forecast your company’s future, you need to have a deep understanding of your company’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 real reason that financial models are built. Models provide a framework for understanding your business, but they don’t mean anything unless you use them to plan for the future.
Forecasting effectively allows a startup to:
- Time key decisions correctly: Startups have 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. Hiring employees too early, going without funding for too long or purchasing expensive equipment at the wrong time could all easily bankrupt your company. Forecasting allows you to predict when your business will be ready for big investments and when it will need new funding so you can prepare properly.
- Optimize its resource allocation: Startups have limited funds and labor hours, so they need to use them both very deliberately. Forecasting allows you to understand the most important levers driving your company’s growth so you can focus your resources where they matter most.
- Pivot quickly in bad scenarios: Every startup should forecast good, average and poor scenarios for the future, then develop plans for each of them. You can avoid being blindsided by results that are less than you hoped for and react to them instantly using forecasting to develop a contingency plan ahead of time.
Budgeting is a subset of forecasting that is hyper-focused on expenses and other cash outflows. It’s one of the most common ways of using the Three Statement Model, though it relies more on the income statement than anything else.
You’ll need to create different budgets for your company at each stage of your growth.
For example, before you’re bringing in any revenue, you’ll want to create a budget simply for the costs to get your product or service ready for sale. But once you’re bringing in revenue, your operations will expand, and you’ll need to refine your budget to account for these new expenses.
The Importance of Budgeting
A budget is an important tool for a startup at any stage, but it’s particularly useful for companies that are concerned with their cash runway. This might be during periods of low revenues or thin margins.
When your startup has evolved past those difficulties, your budget becomes a more analytical tool. Successful financial teams often have monthly or quarterly meetings to compare their budgeted spending to their actual spending, so that they can discover problematic areas and adjust accordingly.
Finally, let’s take a look at a quick outline for building your startup’s budget.
How to Build a Startup Budget
- Determine your fixed costs: these will be hard to cut back on and include expenses like rent, payroll and insurance.
- Estimate your variable costs: these will scale up with your sales and include expenses like raw materials, utilities and shipping costs.
- Calculate your monthly revenue: this may be difficult, but your revenues will be the benchmark against which to gauge your expenses.
- Add in a healthy margin: every business should have a buffer, just to be cautious.
- Sort your expenses into necessary and discretionary: find areas that you can cut back on if need be.
- Adjust as necessary: reduce discretionary expenses to get your expenses under revenues with a healthy margin included.
- Compare your budgeted results to your actual results regularly, ideally every month.
Consider Working with a Professional
Even for the most talented founder, it can be difficult to manage a startup’s financial health singlehandedly. Unfortunately, hiring a team of financial professionals, or even just a Chief Financial Officer, can be an extremely expensive investment.
Unless your startup is already firmly established and highly profitable, it’s unlikely that that expense will fit in the budget. But there is a way for you to get the best of both worlds.
Consider taking advantage of outsourced CFO services. You’ll love the flexibility to consult with a CFO as much as you need, without the expense of bringing on a full-time resource.
Founder’s CPA can help you with your financial modeling, forecasting, budgeting and more. Check out our free consultation to get help with your startup’s finances today.