Financial modeling is an important tool for planning a startup company, whether you want to boost sales of self-published book of ra or just open a startup. It allows you to determine the feasibility of launching a project and attracting investment, effectiveness, and correctness of the development strategy. The lack of an economic model can lead to negative consequences – from unreasonable costs to the complete failure of your idea.
The financial model demonstrates the current state of the startup and the expected course of its development. Building a financial model will give you a tool to understand the strengths and weaknesses of a startup story, ways to optimize costs and increase profits.
It will help potential investors determine if you understand your business and what goals you are pursuing. This article will give you all the details about the financial model and give you some tips for putting it together correctly. Let’s dive in!
Startup Financial Model: Concept and Types
For planning goals, two forms of the financial model are used:
- The financial plan of income and expenses (Profit and Losses – P&L) – forms the development strategy. It is built on an accrual basis (accounting is not associated with the actual movement of startup fundsbut with the date of service provision, product transfer, and so on). You might also be interested in online entrepreneurship courses.
- A cash flow statement (CF) is used for operational management and planning of cash flows. Its creating is carried out on a cash basis: to classify amounts as income or expenses, the actual money movement is required (when they entered or left the account).
It is often enough to have a cash flow statement and plan based on it at the initial stage. This report serves as a good indicator of business performance, helps the founder avoid cash gaps, and predicts the moment of attracting investments. The startup financing indicators (NPV, ROI, IRR) are calculated based on the projected CF. Some investors use these indicators as criteria for making a decision.
As the company grows, you will need to expand the reporting and planning system. Then P&L will appear with the ability to calculate revenue, net profit, break-even point, and project payback.
If you have a large time lag between the moment the service is provided, the shipment of the goods, and the receipt of funds, it is recommended to build a financial model based on two reports – CF and P&L.
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Why Do You Need a Financial Model?
Startup financial modeling is applied to:
- Justification for a company’s concept – the plan demonstrates the sources of income and costs, the volume of the market, and other indicators of the organization’s activities.
- The attraction of investments – based on the startup business planand financial model, investors assess the company’s value and decide on the feasibility and amount of investments.
- Development of the company’s strategy – the plan shows the strengths and weaknesses of the company, the main economic factors affecting business growth, focus on KPIs. Analytics allows you to optimize and improve the efficiency of activities, to quickly respond to market changes.
- Benchmarking – comparing a company’s performance with the performance of successful competing organizations.
- Forecasting – an analysis of the revenue and expenses explains when the break-even point will be passed. The plan shows how quickly the startup spends money, whether these costs are justified, and when it is necessary to conduct an investment round.
The goal of the financial model is not to guess the future of the company, but to understand the business processes of a startup and the factors affecting its growth. Since the plan is based on hypotheses, it needs to be updated regularly (when actual sales, revenue, costs appear.) In this case, the model serves as the basis for determining the correctness of the chosen strategy and, if necessary, revising it.
Rules and Features of Building a Model for a Startup
The model of a startup is based on a business model. It is a description of the target audience, customer acquisition processes, product features, etc.
When building a startup model, it is recommended to observe the following rules:
- Maintain maximum flexibility – indicators that suggest changes should be displayed on a separate line (for example, the product’s price). You should be able to easily adjust details at the slightest change in the plan. As a result, the interrelated elements will also change due to the formulas.
- At the initial stage of a startup’s development, it is recommended to focus on key metrics and limit them to the most important ones. Your financial model should be as simple as possible.
- To build a model close to reality, it is useful to study the market averages. Such an analysis will help you to prove to investors the objectivity of the created layout.
- Thinking about reserves – A common mistake startups make when creating a financial model is the desire to present an ideal picture of the company’s development. In practice, however, this leads to significant deviations from the plan. It is important to consider different scenarios (pessimistic and optimistic) and provide for reserve funds.
How to Get Started with a Startup Financial Model
It is necessary to build a startup’s financial model from simple to complex. Initially, you should create a basic layout of the business, build connections between its elements. Then, as the startup business grows, supply the model with indicators corresponding to the stage of development.
The main stages of building an economic business model are:
- Analytics and structuring of income.
- Drawing up the consumable parts.
- Analysis of operating activities (production and sales of products, efficiency of employees, fixed assets).
- Adding indicators based on the characteristics of the startup and the stage of development (taxes, interest on startup loans, and so on).
You can build a model yourself or use the help of professionals. At the initial stages of the company’s development, you are quite capable of doing it yourself – creating a table with the necessary economic indicators in Excel or using ready-made templates. It will allow you to deeply understand business processes, control and effectively manage a startup, show investors “understanding” of your project and development strategy.
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How to Estimate Earnings?
The model reflects:
- all sources of startup income;
- sales plan;
- sales market analysis;
- total incoming cash flow;
- cost of sales.
The result is the definition of operating profit – it should be positive, at least in the forecast scenario. In the first months of the launch, negative values are allowed – when the profit does not cover the startup costs. But in the long term, the company should be profitable in terms of operating activities. Otherwise, it will go bankrupt or require new investment rounds.
When determining the income, it is important to consider the characteristics of the product. Seasonality can also be attributed to the features of the product.
The income statement in the financial model contains both real numbers and planned ones. At the initial stages of a startup plan development, a layout can only consist of a forecast. To determine income, the following methods are used:
- Top-down. You need to multiply the target market size by your estimated share in it (which the company can occupy). For example, a niche has 7 main competitors that have taken 70% of the market. Then you can plan to own 10% in 5 years (70%/7). To determine the profitability, the share is multiplied by the estimate of the target market.
- Bottom-up. In this case, you should multiply the average income from one customer by the expected number of customers. For example, if a business requires a subscription fee, its average value can be taken as an average profit.
To determine the income, you can choose one of the methods, but it is better to use both – display the total value if there are mistakes (improving the indicators in which you are less confident).
Planning Startup Costs
When building a financial model, all real and projected costs of a startup are taken into account:
- for the creation of a product, including capital, for the purchase and modernization of fixed assets (equipment, technologies, real estate, and so on);
- related to the promotion and sale of the product;
- permanent – salary, rent, utility bills, and so on.
In this part of the model, it is advisable to determine the gross profit – the difference between the revenue and the cost of the product sold. When making forecasts of the expense side, a detailed analysis of the market will be required. Estimating most of the costs is not difficult – just call the landlords, check the average salary of specialists on recruiting sites, collect data on prices for advertising, marketing, ask suppliers for the cost of the necessary equipment, raw materials etc.
When drawing up the expenditure part of the model, it is important to consider the peculiarities of costs. For example, when determining the amounts for employees’ salaries, additionally include insurance, bonuses, and other expenses. When developing a model for several years (usually 3-5), the growth due to inflation should also be taken into account.
The more accurate the plan is, the more likely you can choose the right startup strategy. Detailed cost analysis significantly reduces the risk of a cash gap typical for new businesses when there is a temporary shortage of funds required to cover costs.
The main task of structuring startup performance indicators is to determine how profitable the project is in the future. If the economy does not converge even on paper, these startup ideas should be rejected. If the project seems to be profitable, the layout will help determine the target rates necessary to reach the break-even point and further growth.
If a startup has not yet been launched or is just starting its journey, the financial model looks as simple as possible and includes only the basic elements (income, expenses, and ratio).
A startup from zero must always be ready for change – this is one of its features. As a result, the financial model needs to be updated accordingly. At the same time, the layout must be built so that the adjustment takes a minimum of time because the task of a startup is still to make a profit and not to create tables.
Please share your experience in drawing up a financial model in the comments below. What element do you consider most important?
Arthur is a digital marketing specialist and business blogger. He develops interesting startups through various social media and shares his experience with clients to better promote their business. In his spare time, Arthur studies Japanese and writes articles on digital transformation trends.