Financial models can be daunting if you don’t have a financial background, but they are critical tools for quantifying and defining your businesses’ financial needs and goals. Financial models are rooted in the revenue and expenses associated with your operations. With the help of these models, you can make sound, researched decisions about the future — and expand or pull back payroll spend appropriately, for example. A good financial model will provide you with insight into your burn rate, hiring plan, and cash runway while also helping you plan for your next fundraising round.
Understanding Financial Modeling
Put another way: a financial model is a formula. In its simplest form,a basic income statement model will read:
- Revenue – Cost of Goods Sold = Gross Margin.
- Gross Margin – Operating Expenses = Operating Income
- Operating Income + Other Income – Other Expenses = Net Profit
Using your historical financials, operating data, and future milestones you can make educated assumptions about how your business will perform in the months and years to come. Things to think about include:
- How much can I reasonably expect my revenue to grow, when will new products launch and how will we sell them? What about Churn?
- For “Cost of Goods Sold”, what are all the costs I would incur to deliver a product, service or good?
- With “Operating Expenses”, it’s helpful to use a few summarizing expense buckets – General Administrative Expenses, Sales and Marketing Costs, Payroll, and Engineering Costs are usually a good place to start for most companies.
All good assumptions are based on data, comparables, market intelligence and past operations. It is critical to be mindful of the veracity of your assumptions, and that their accuracy will decrease over time. While on paper you can show how your company could generate a billion dollars in revenue next year the assumptions that got you there should be grounded in some tangible reality. Especially if your model is going in front of investors, employees and other stakeholders.
In addition to the income statement model above, also use more advanced financial formulas to better understand your business’s standing and opportunities in the future. Startups and corporations alike use financial models to determine whether or not to:
- Invest in different marketing and distribution channels
- Make cash disbursements
- Grow organically vs. spending on digital advertising and sales teams
- Budget for industry stall-outs
- Invest in research and development, capital projects or acquisitions
- Take on more business debt for the sake of expansion
While every financial model is different, they all generally have a similar anatomy, including: A clean worksheet identifying key outputs from your calculations, a separate assumptions page or section, metrics and ratios, and a clear logical flow for all tabulations. At your earliest stages, the income statement model described above will serve you well. As you grow, however, additional layers around different financial statements, budgeting, scenario planning, cash management will become a need-to-have for you and your team to effectively manage your business.
Financial Models: Your Options
As mentioned, there are more financial models available to you than the ones you can use to determine gross margin and income. Startups looking for financial models to use will be able to take advantage of the following:
- Three Statement Model – the three statement model is the ideal starting point for most companies and should be the core of many of the other models listed below. This model marries your business’s income statement, balance sheet, and cash flow in a worksheet, allowing for each statement to influence the flow of the others.
- Budget Model – if your team wants a financial plan for the year, or if you individually want to create a budget for the year to come, then the budget model is the one for you. You’ll need to base your budget model on the financial data from your most recent quarter or month of operation for the most accurate results. Be sure to focus on your income statements as you go, as this is the basis for any budgeting project. Pay special attention to how costs will grow with additional headcount and revenues!
- Forecasting Model – the forecasting model works in tandem with your 3-statement model and is typically just an extension of your financial statements, with some forward-looking assumption built in. This is the type of tool you would use for scenario planning on hiring, understanding the efficiency of your marketing funnel as you tweak it in the future, or how the next investment will impact your business. While these are the trickiest to build, they can be the most informative with the right assumptions and research.
While you can build these models on your own, you don’t have to. airCFO works with a variety of technologies and tools, but we’ve found that there are really two core offerings for building something robust from scratch or a template:
- Microsoft Excel – there is no program more universal to startups than Microsoft Excel. You can use pre-made Excel templates to monitor your startup’s finances or use the program’s tools to create your own.
- Google Sheets – if you’re interested in working via the Cloud, then Google Sheets serves as an Excel-affiliate that keeps your data online. Reasonably secure and great for remote employees, Google Sheets also comes with pre-made financial templates that you can use at your leisure
When you use these tools, keep in mind that all financial models require basic building blocks. These include a forecasting functionality, actual management functionality, differentiation between your sources of data, and a change log that allows you to note how your finances have evolved and what business decisions have worked in your favor.
Financial Models & You
You can learn how to create a financial model on your own time. If this is the path you want to take, be prepared to spend several weeks looking into equity research reports created by other companies, learning how to build financial statements, and then actually doing the work. By assessing the way financial executives and leaders view financial problems and modeling, you’ll develop a better idea of how you can apply the business models mentioned to your own startup.
Want to learn more about how financial modeling can help your startup? airCFO’s in-house model is your 1-stop shop for all your financial management needs.. With the help of the airCFO team, you can quickly implement our model and budget for your startup’s success.