Financial Model Definition, Component, and Benefits
Financial Model Definition and Component
As mentioned, a financial model is a tool for analyzing current performance, comparing it with the past, and predicting the startup’s financial performance.
The founders design financial model based on historical financial data, assumptions, market and industry facts related to the startup, profit and loss statements, balance sheet, and cash flow. A financial model is a numerical translation of a startup’s business model, strategies, growth model, and vision in Excel spreadsheets.
When we talk about the model, what comes to mind is a three-dimensional object that we can go through from different angles and aspects. A financial model is also a tool that helps look at the startup from different perspectives considering different assumptions and possibilities for its future.
What Are The Benefits of the Financial Model?
The outputs of the financial model will assist founders as well as venture capitalists in financial decision-making and analysis:
- Startup valuation
- Analysis of historical startup data
- Raising capital through the share transfer or loans
- Budgeting and budget forecasting
- Merger and acquisition
- Startup development (entering new markets and geographical expansion of the service area)
- Sale and transfer of assets
The financial model includes the following:
- Facts, hypotheses, and historical data
- Balance sheet
- Profit and Loss Statement
- Cash Flow Statements
- sensitivity analysis
- Key performance indicators of startup
- Cost structure
- Charts and graphs
What Is A Balance Sheet?
The balance sheet shows a snapshot of a company’s assets and liabilities as well as the amount of stakeholder investment. In fact, a balance sheet is a financial statement that shows how a startup’s assets are secured through loans and equity.
Cash Flow Statements
The cash flow statement shows how much cash the founders have spent on the startup over a while. The cash flow statement provides valuable information about startup cash-generating activities. The three main categories of activities that are reflected in cash flow include operating activities, investment activities, and financing activities.
Profit and Loss Statement
The profit and loss statement summarizes a startup’s income and expenses and reflects how the startup performed financially during a given period. In fact, the final output of this financial statement is the amount of profit or loss or the economic performance of the startup during the financial period.
Key Performance Indicators
Given the industry and the nature of the business, the founders should include the most important metrics in the financial model for investors and founders. Some of these indicators can be measured and monitored using profit and loss statements. For example, gross profit margin, EBITDA, measures the startup sales and profit performance, or indicators such as customer acquisition cost or CAC, customer lifetime value or LTV and drop rate or Churn Rate, etc.
To read more, refer to the article 5 indicators that you should not neglect to observe.
Financial Model Inputs
Historical Data, Facts, and Assumptions of The Financial Model
Historical data, if any, are the first inputs to the financial model and are the basis for calculating revenue growth, profit margins, user growth, financial forecast, and so on.
Given that not much historical data is usually available for startups, predictions need to be based on facts and assumptions. These hypotheses are based on market research, contracts with suppliers, conversion rates, website traffic, list of consumables, cost of consumables by detail, and so on.
Earnings Role in Startup Financial Model
After historical data, income is the most critical input of a financial model. However, depending on the stage of development and the nature of the business model, the startup may not have generated revenue in the early stages. In this case, the founders estimate revenue based on market size.
As we mentioned in the market size estimation post, there are two top-down and bottom-up approaches to calculating the market size and, consequently, the market share the startup intends to capture. By calculating the market share, founders can estimate the revenue.
To calculate the market size more accurately, founders should compare the results of both methods, as the top-down method may provide optimistic estimates.
Using the bottom-up approach for short-term revenge and the top-down approach for long-term forecasts is more beneficial. The combination of these two methods provides more accurate outputs for estimating startup revenue.
Costs in Startup Financial Model
After estimating revenues, startup costs should be calculated:
- Costs of goods and services
- Operating costs (sales and marketing costs, research and development costs, general and administrative costs)
- Human resource costs
COGS (Cost of Goods and Services)
This cost includes the product or service providing or manufacturing cost and varies based on the business nature. Consider the following examples:
For a startup that sells detox juices online, COGS costs include fruit cost, bottle, box, and labels. To be more precise, in a detox juice startup, the founders must calculate the cost of a plastic bottle, its label and box, and the amount of fruit needed to produce each bottle of juice.
On the other hand, for a startup that provides online consulting services, the consultant’s salary is the major part of COGS.
For a SAAS startup, the cost of servers, customer support, etc., are among the cost of goods and services.
As another example, for a food ordering platform, the average shipping cost per order is part of this cost.
Costs incurred by the startup’s everyday processes. Unlike COGS costs, these costs are not necessary to produce the product or service. However, some costs are vital to supporting and keeping a business afloat. The costs of licensing, promotions and marketing, rent, insurance, prototyping product, and consumables are among the operating costs.
Human Resource Costs
Human resource costs are perhaps the most straightforward part of calculating the costs of a financial model. These costs are calculated based on the departments, the number of employees, basic salaries, bonuses, and jobs received.
For example, imagine a startup with a technical, support, marketing, and sales department. The number of people in each department, along with their salaries and bonuses, must be determined to calculate total human resource costs.
Expenses related to taxes, income, non-operating expenses, repayment of principal and interest on loans, etc., are other parts of a financial model that you must calculate based on startup type.
After calculating costs and subtracting them from revenues, you can reach the startup profit or loss.
What was mentioned was the initial guide to getting acquainted with the startup financial modeling. The financial model is the basis of startup valuation. To learn more about valuation techniques, read Valuation Methods.
If you want to build a functional and readable Excel for your financial modeling and forecasting, pay attention to colors. Distinguish the inputs of the financial model, including assumptions, facts, historical data, and computational output cells, with different colors. For example, show historical data in gray, assumptions and facts in pink, and cells containing computational output in blue.