What is financial modeling?
Financial modeling is the process of building a financial picture of how your business might look in the future. Typically financial modeling is done in spreadsheets. The models can be quite simple, with just yearly revenue and cost expenses, to vastly complex models pulling in large amounts of data. Start simple and the model will evolve. The key is to start with supportable population inputs, justifiable assumptions and to make sure everything links together and flows. Use formulas and link cells, don’t use hard pasted numbers.
Input – target population
The starting point to a strong financial modeling is reliable and accurate data inputs. What is your starting point? If you are developing a new business who is your market? Do you have accurate details on the size of the market? The number of customers? Is your product or service suitable for the whole human population? Or is aimed at a specific audience? Is your target market just local, domestic or can you scale internationally? It is essential that you start with accurate and proven facts on the size of your target population.
Are there any other limiting factors you need to build into the model? Is there a limit on the availability of specialised staff? Limits on other resources? Capacity limits?
You need to make reasonable assumptions in your financial modeling. What percentage of the target population do you reasonably expect to gain? This will depend on factors such as the size of the population and your competitors. If you have competitors what percentage of the market do they already have and how do you expect to take market share away? Is your target population expected to grow or is it shrinking? Is it growing because of age or regional demographics? What will it take to achieve your targeted percentage of the population? Does it require education and persuasion? How much do you need to spend to attract and covert customers to your product?
You also need to consider growth in the prices of your services and products. Are you building inflation into your model?
What period of time are you going to project over in your financial modeling. A startup will typically require projections for 3 to 5 years, but in some cases a company may produce a model for 10 years.
What time factor are you going to use? Usually this would be projections on a monthly basis. In cases of very quick growth perhaps weekly forecasts might be appropriate.
Revenue will be a function of target population size, expected take up of the population and the price you can charge. You also need to think about what the others drivers of revenue are: employee driven, investment driven, capacity driven, .
You might simply have one product and one price. Or you be able to offer different products and services at different prices. For each product and service you need to link to the population input and conversion expectations. Don’t double count!
Costs of sales
To a certain extend this is the easier bit. Your costs of sales should be a function of revenue. Once you are up and running this cost of sale should become more consistent.
Sales & Marketing expenses
The key expense for a startup. How much do you need to spend to convert a potential target to paying customer? Once you are up and running then you should start to get an idea of roughly how much you have to spend to attract each customer, to generate revenue. You need to make sure you’re not spending more than the customer can generate!
Salary costs are often one of the highest expenses. Some salaries will be fixed as an overhead, irrespective of the number of customers. Whilst others staff costs will be a function of the number of customers and so revenue. As you grow and revenue increases, salaries are going to increase.
Are there any other expenses that link to revenue? What other overhead costs do you have? Rent. As you grow will you need bigger premises? Utilities, the larger the number of staff and the premises the higher the utility bills.
What do you need to invest in the assets of the business to be able to generate future revenue? Does your business need significant investment in research and development? Do you need computers? Any vehicles?
The financial modeling also needs to consider the working capital requirements of the business. How long will it take to get paid by customers? What credit terms are offered by your suppliers? What levels of stock will be required to be held? This is important analysis for establishing your levels of cash at each period.
Funding needs to be built in to the financial modeling. When do you expect to receive cash funding? Is it to be received in tranches? If you have debt funding, when do debt payments have to be paid out and what interest has to be paid.
Once you start generating profits you need to account for tax. You need to consider what your real rate of tax will be, ie. do you have any deductions to reduce your tax liability? When will your tax liability be payable?
Financial modeling uses
Financial modeling can be used in a number important ways.
- Raising finance: They can explain to potential investors how you expect this business is going to generate cash
- Valuation: The model can be used calculate a value for your business which can assist in the funding process
- Cash flow: Importantly the model can show you when you will need funding and the critical times in the business
- Three way forecasts: Models can incorporate not only income and expenses but also the balance sheet and cash flow to provide a full financial picture of the business
- Sensitivity analysis: The nice thing about models is you can adjust the variable to see what affect it has on the bottom line profit and cash flow. This can be very useful to identifying key risks and how to manage those risks.