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What you need to know about financial modelling

Do you find finance and numbers overwhelming?

Is finance a sensitive topic for both your business and you? And you don’t want to talk about it?

Do you have a difficult relationship with numbers and feel underconfident?

Do you want to build a financially sustainable business, but don’t know where to begin?

If the answer is 'YES' to any one of the above questions, then read on…

What is a Financial Model?

A financial model is a translation of your business ideas into numbers, it’s the art of telling/re-telling your story using numbers, it’s basically a mathematical representation of your company. Your financial model is a living, breathing entity that will serve as a powerful decision-making and forecasting tool – the emphasis on the word ‘tool’. That’s right! It’s a tool that can be shaped and moulded for you, by you.

Why a Financial Model?

A Financial Model gives direction and helps you and others understand the health of the business. It’s a strong indicator to investors that the founder is aware of their business and has a roadmap to drive their business forward.

However, it's essential to understand that financial models are driven by assumptions and often may be way off the actuals. It is hence imperative to record the actuals against the assumption, monitoring their progress and closing the gap so the accuracy of the model improves over time.

Where should I begin?

You start financial modeling by moving yourself, quite literally! Getting over the fear, intimidation, and inertia attributes to 90% financial modelling. The remaining 10% will be the following:

Identifying your business KPIs

For an e-commerce business COGS (cost of goods sold) is a KPI vs. for a SAAS business CAC (cost of acquiring/retaining a client) is a good KPI. While both are cost KPIs, COGS is directive of costs associated with raw materials, manufacturing, where as CAC is directive of costs associated with marketing and sales.

Thought partnering on your assumptions

Your business is unique, and so are your assumptions. Assumptions should be well-researched, reasonable, and simple. For instance, a new business will spend more on marketing and sales vs. a mature business, so using market benchmark values for marketing and sales will skew your business story. Remember that assumptions are fluid and will change as your business and market changes.

Start-up Financial Model

The two main methods to build a financial model for start-ups are top-down and bottom-up:

Top-down method

In this method, we start with the big picture, systemically breaking it down to targets/milestones the business needs to achieve. For instance, if you want to build a platform to identify and host all the healthcare services available around you, we begin by identifying the market size, say its $30 billion and by year 2 (starting from zero) you want to capture 2% of this market, you’ve defined the revenue you want to achieve by end of year 2 (2% of $30 billion). Using this defined revenue, you calculate the costs associated to reach your revenue targets.

Bottom-up method

In this method we start with the basic assumptions for both cost and revenue components, such as marketing, commissions, people, sales and recurring revenue. We then manage/adjust the assumptions for different scenarios to achieve the business goals

For start-ups the top-down method can provide insights into milestones, however, can be prescriptive, less flexible, and overly optimistic. The bottom-up method will provide a better understanding of the business, however, can be cumbersome. A good and balanced approach will be to have a bottom-up model, to provide structure to the business, while also providing some top-down strategic view

Types of Financial Models

There are different types of financial models for different types of businesses. The most used financial models, especially by start-ups, are the following:

3 – statement financial model

The 3 types of financial statements are income statement, cash flow statement, and balance sheet. The 3-statement financial model will link all 3 financial statements together, using historical data and assumptions to drive accurate forecasts.

For instance, if you want to understand the impact on cash flow or debt from operational decisions such as lowering price or investing in a business tool, then the 3-statement financial model will come handy.

Discounted cash flow analysis

This model enables the valuation of a business by forecasting its free cash flow. This model will predict how much money the business will make in the future. Using market discount rate on the cash flow, this model will help determine the Net Present Value (NPV).

For instance, if you want to evaluate investment opportunities or launch a new product, the NPV will provide details on how much money is needed for this investment.

Sensitivity analysis

This shows the effects of changes to the assumptions. By analyzing different scenarios, you can understand the impact on revenue, costs and other KPIs.

For instance, if you want to increase the selling price, then through scenario analysis you can see the effects of this change across the business.

The idea of financial modeling and translating your business into numbers can be daunting. The important thing to remember is that the model is yours. It can be interpreted and changed by you. Owning the model as much as you own your business will empower and enable you to put your best foot forward. Investors are only trying to understand your business in the language they know i.e. numbers. You have the power to tell your story. Let’s MODEL!

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