Whether you’re building a pitch deck or just want to understand whether your business idea is viable, you’ll need a financial model.
In fact, it’s impossible to create a cohesive story behind your business plan without a financial model. The model IS the business plan—and financial backers know it. So if you’re raising money, step number one is always to work the numbers into a model.
A financial model is a tool that helps you predict the future financial health of your business. Using a financial model allows you to see if or when your startup might become profitable. It can also help you predict and understand where you might run into financial trouble if you don’t make some changes.
Read on to find out more about financial models and how your business can start building an accurate model.
Why is an accurate financial model important?
A better understanding of business finance is never a bad idea for any business owner. But for startups, where the margin for error is thin, it can be the difference between staying in business or shutting down your operations.
Below are a few of the main reasons why investing the time—and potentially the money—in creating an accurate, actionable financial model is in your startup’s best interest.
You’ll better understand whether you’re building a viable business
To build an accurate financial model, you’ll have to dig into past and current performance numbers, as well as do some market research. Armed with those numbers, you’ll have a better idea of how your business is doing now, as well as how you’re performing compared to your competitors.
By using a financial model to project those numbers into the future, you’ll be able to see where your expenses might start to eclipse your revenue. You should also be able to see where you’ll start to break even. Either way, you’ll have a better idea of potential financial pitfalls or where you need to make changes to get into the black.
You can track your progress against expectations
If you’re armed with a financial model, you can see how your performance over time tracks with your projections. You’ll also be able to update your financial model as you gather more data, making it a useful living document instead of just a record of your financial hopes and dreams for your business.
With continuous financial monitoring, you can see where your projections might have been off—and analyze why. You can also quickly see when you need to take action to reach your financial goals.
You can raise money with more confidenceIf you're looking for funding, a financial model will be the most important tool in your pitch. Investors and shareholders will want to understand how you expect your business to perform before they give you a cent. Click To Tweet
When you can point to the justification for all your numbers and know you’ve used all the right calculations to create your projections, investors will have more faith in your model. Plus, you’ll also have an idea of exactly how much money you’ll need to raise based on your projections.
Caption: Show off your startup’s projected earnings to raise funding from investors.
What numbers do I need to build my financial model?
Unsurprisingly, you’ll need quite a few numbers to start projecting your startup’s financial performance. Along with the critical numbers you’ll need to come up with, I’ve included some guiding questions to help you think about each of them. However, you’ll have to drill down into each projection based on your startup’s industry and historical performance.
How much money does your business bring in? How much do you charge for each product or service? How will those numbers change based on increased capacity and funding or an expanded product range?
Cost of good sold (COGs)
What do you need to spend in order to make your products or deliver your services? How much does it cost to create each unit of your product? How much commission do you pay your sales staff? How will those costs change based on your sales projections?
Operating expenses (OPEX)
What do you need to spend so your business runs, in general? Do you rent office space? What are your payroll costs? Do you host (or plan to host) large events for clients or customers? How will those expenses increase as your business grows?
How many employees do you have? What do you spend on salaries, benefits, and taxes? How will these costs change based on new hires or expansion to different regions or countries?
Capital expenditures (CAPEX)
What do you spend on physical assets? Do you provide laptops and office equipment for your employees? Did you purchase a building to use as an office or production facility? What other purchases will you need?
As you’re tallying up your capital expenditures, you might wonder how to differentiate them from operating expenses. Investopedia has a helpful, in-depth explanation. But in summary, you can include costs incurred from the purchase of physical assets you’ll own and use for longer than one tax year (hardware, real estate, etc.) in the CAPEX category.
What’s your overall equity? Have you taken out any loans? How much of the principal have you repaid? How much have you paid back on the interest of the loan? Have you received any government subsidies? How do you expect these numbers to change over time?
How do I find the numbers I need?
There are two common methods you can use to come up with your numbers. I’ve outlined below, as well as when and why you should use them.
With top-down forecasting, you’ll use industry estimates and other researched data to make predictions and create data where you don’t yet have it.
The cornerstone of top-down forecasting is the TAM SAM SOM model. Using this model, you first find the value of the total available market (TAM) for your product or service. You then estimate the reach your product or service could have within the market. This estimate is called the serviceable available market (SAM). Within the serviceable available market, you’ll want to predict the serviceable obtainable market (SOM). This segment of the market is the part of the market you think you can realistically bring on as a customer or client.
Your SOM number is your new sales target. Using your sales target, you can work backward to calculate revenue and COGs and better predict OPEX and other expenses.
Pro: Top-down forecasting helps you understand the market at large and gives you goals to reach. It also helps you take your competitors into account and gives you an idea of where the ceiling for your market share might be.
Con: Since top-down forecasting is based on estimating your market share and working backward to come up with the numbers you’ll need to have to reach it, you could end up creating overly optimistic projections that don’t accurately represent your business’s capabilities.
Bottom-down forecasting uses existing data from your company and bases projections on past and current performance. Instead of trying to estimate the percentage of the market your product or service will capture, you’ll use historical data and past growth numbers to predict it.
You can also use historical data on spending to predict how your expenses will change over time as your business expands.
Pro: Bottom-up forecasting helps you create more realistic—or at least more conservative—projections. Instead of basing your predictions about the future on an educated guess about your future SOM, you’ll have concrete numbers to base your assumptions on.
Con: Since bottom-up forecasting is more conservative, it can lead to an underestimation of your business’s growth. It doesn’t necessarily take the possibility of acquiring tons of funding or experiencing a boom in sales into account.
Which forecasting method should I use?
Ultimately, both! These two methods of forecasting serve different purposes.
Bottom-up forecasting is better for short-term projections. It reflects your business’s past and current capacity and gives you an idea of growth based on how you’ve already performed and grown.
However, top-down forecasting is better for creating projections in the long term. Since you start from where you want or expect to be in terms of market share, it reflects the potential of your business. And while you still might create some overly optimistic numbers, using them to create projections for a few years down the road gives you the time to figure out how to reach those numbers.
Filling in the gaps
As a startup, you won’t have years of historical data to fall back on, so even your more conservative bottom-up forecasts could involve some guesswork.
However, you should never just pull numbers out of the air. Guesses in your financial model should always be educated guesses, and every estimate should be backed up by solid research.
If you’re a SaaS company whose product is still in beta, for example, you can use hard data such as website traffic, the number of people on your waitlist, and even keyword search volume related to your product or service to project future sales and revenue.
And even if you have reams of historical performance data to work with, you should still conduct market research and dive into any performance metrics that could help justify any numbers in your model.
What do I need to include in my financial model?
A financial model can include each of the following parts, details, or sections. CFI has a more technical breakdown of these different sections, but I’ve tried to summarize what’s included and the purpose of each section.
Caption: Start putting all your numbers together in the different sections of your financial model.
Include your assumptions about your future business performance here. A SaaS startup, for example, might assume a certain number of users in their first month of operation. Whatever your assumptions are, make sure you have research-based justifications or historical data to support each of them.
Your income statement will show the projected revenues and expenses for your business. Based on the numbers in your income statement, you’ll be able to calculate your earnings before interest, taxes, depreciation, and amortization (EBITDA).
The balance sheet gets its name from its purpose: you want to show that your assets (the resources your company owns) are equal to the funding you receive for those resources (liabilities and equity). If you have an unbalanced balance sheet, you’ve likely made a calculation error.
Supporting schedules break down your balance sheet into more specific categories to give them more context and detail.
Cash flow statement
The cash flow statement shows how cash enters your business through sales and other revenue sources and exits it through ongoing expenses.
A sensitivity analysis shows how sensitive different metrics in your model could be if any of your assumptions change. For example, if you really under- or over-project sales, the sensitivity analysis shows how dramatically that could impact predictions about the rest of your company’s financial data. Using these analyses, a potential investor can better calculate risk. And your startup can give them more faith that their investment is solid.
Charts and graphs
Including charts and graphs helps anyone looking at your financial model better understand it at a glance. Instead of forcing potential investors to assess your startup by going through tables line by line, your charts can provide easy answers.
Caption: Tables provide detail, while charts provide summaries.
Create an accurate, thorough financial model with financial modeling software
As you can see, a lot of work—and a lot of data—goes into creating a functional financial model. There are a lot of moving parts and a lot of places where you could make a mistake.
That’s where financial modeling software comes in. With built-in templates and a method that walks you through the process of finding all the information you need, you can:
- Avoid the headache of checking your spreadsheets for calculation errors
- Create usable, readable graphs and charts for yourself and potential investors
- Ensure you’re not missing critical steps in the model creation process
- Include all necessary data points for your projections
- Use a flexible model that allows for various types of forecasting and continuous financial monitoring.
If you want early access to a tool that can do all these things, sign up for RaiseIQ’s waitlist. Our software will help you save time and money building a financial model so you can understand your business’s finances, raise money, and gain peace of mind knowing you’re building a viable business.