What Is Financial Modeling?
In the simplest terms, financial modeling is a tool that’s used to forecast the future financial performance of a business in the future. A financial model can be as simple as an excel spreadsheet that takes the historical performance of a company (or financial projections) and compiles it into an easy-to-read report.
Building financial models requires preparing a balance sheet, cash flow statement, income statement, and any supporting schedules in order to establish the base of the model.
After all of the company’s core financial data has been collected and compiled, the next step is to develop more advanced financial models using that data, such as:
- Sensitivity analysis
- Leveraged-buyout (LBO)
- Discounted cash flow analysis (DCF)
- Mergers and acquisitions (M&A)
Your startup’s financial model is a forecast of your company’s earnings and expenses in the future and plays an important role in future decision-making.
Investors will likely want to see your financial model before they give you their capital in order to understand your company’s vision and establish a risk to reward ratio for their investment.
If you can show your startup’s future growth potential and describe how this growth will happen in detail, you’ll have investors jumping at the opportunity to invest in your company. The most challenging part is taking historical data, industry knowledge, and technical nuances and combining them all into an effective financial model.
Why Is Financial Modeling Important for Startups?
Startups need financial modeling to raise capital and take on outside investors, as it shows your company's projected growth, profitability, and expenses in a clear and concise manner.
If you’ve been eyeing investors to raise capital or want to sell your company to an acquirer in the future, your financial model can be one of the most important documents you create when it comes to persuading others about your company’s future.
In essence, your startup’s financial model is a numerical expression of your vision and goals. This is where you describe how many people you'll hire, how many customers you'll have in the future, and how your financial projections over time.
Before you begin executing your business plan(s), it is extremely valuable to build a financial model to help clarify and “tease out” all of the assumptions and metrics you've put together in the planning process.
Before you begin executing your business plan(s), the creation of your startup’s financial model will help you clarify and “tease out” all of the assumptions and metrics you’ve put together in the planning process.
It’s important to understand that even the best financial models aren’t always “right,” but seeing the differences between what you modeled and what actually happens can be incredibly insightful, allowing you to make beneficial changes and pivot very quickly.
All in all, your startup’s financial model is what helps investors, team members, and potential acquirers see your company’s potential. It also allows your internal and executive teams to make better decisions, using your financial model as a guide.
Different Types of Financial Modeling
There are several different types of financial models used by startups, including the three-statement model, sensitivity analysis, scenario analysis, strategic forecasting, and discounted cash flow analysis.
If your startup has been around for a while, using your company’s historical financial data, market analysis information, and industry data can help you develop a more accurate forecast of the future.
If you are starting from scratch without much sales history or customer satisfaction data, you’ll have to determine what source of data to use as the core of your financial model. This may require looking at market research and industry trends from sources such as Dun & Bradstreet or Standard and Poor’s (S&P) in order to get the national averages for your industry or look at adjacent markets and adapt their numbers accordingly.
The three-statement model is considered the most important financial model your startup can create, as it forms the foundation of every other financial model you’d like to develop.
The three-statement model consists of three core financial statements:
- Your startup’s income statement (revenue and expenses)
- Your cash flow statement (money out vs. money in)
- Your balance sheet (assets and liabilities)
By combining and aggregating data from these three financial statements, you’ll be able to forecast expenses and revenue for a given period of time. For example, you’ll be able to predict future growth and cash flows, as well as analyze the effect of one variable on another, such as how a demand shift will impact your future revenues.
After you’ve developed your three-statement financial model, you can begin to build upon this data to create more advanced models that take even more aspects of your startup into account.
A sensitivity analysis, also known as a “what-if” analysis, is used to show how changes in supply chain costs, prices, forecasted sales, delivery costs, fixed costs, or other input variables could affect your business in the future.
This type of financial model works by changing one variable at a time and analyzing the results after each change.
Sensitivity analysis will allow your startup to answer difficult questions, such as:
- “How does an increase in packaging costs affect future revenue?”
- “What could happen if we increase our advertising budget?”
- “If we change our average order value, can we break even or even increase our profitability?”
Performing a sensitivity analysis for your startup forces you to consider “what if?” and then plan for those scenarios.
It challenges you to look at all of the assumptions you’ve made in your company’s forecasting and consider how reliable your assumptions actually are.
Running a sensitivity analysis on your startup is a great way to make your forecasts and assumptions more resilient and understand how each individual input variable might impact your growth in the future.
Scenario analysis is very closely related to the “what-if” or sensitivity analysis we just discussed. Instead of only changing one variable at a time, however, a scenario analysis changes multiple variables or all variables simultaneously.
Just as the name suggests, you’re looking to identify potential “scenarios” that can affect your startup in the future and look for ways to mitigate any negative effects that may arise from those scenarios.
This type of financial analysis looks at what happened in the past and tries to model what may happen in the future.
You’ll typically run a scenario analysis related to:
- Your startup’s base-case
- A worst-case scenario
- A best-case scenario
By understanding what could potentially happen with a major shift in your business, you’ll be able to plan for scenarios that could have a major impact on your company.
Depending on your industry, your scenario analysis might include events such as a natural disaster, the loss of a large customer or client, a worldwide pandemic, supply chain slowdowns or disruptions, or a number of other scenarios that may be plausible in the future.
Strategic Forecast Model
A strategic forecast model is used to determine how certain initiatives your startup is considering could impact your strategic goals and vision.
This type of modeling is sometimes referred to as “long-range forecasting” and helps your company determine potential outcomes very far into the future.
If your startup is expanding, for example, you can use strategic forecasting to determine how opening up another business location or building a brick and mortar store in another city would affect your business.
Discounted Cash Flow Analysis
Due to the time value of money, a dollar today is always more valuable than a dollar in the future. Discounted cash flow analysis attempts to take this variable into account, knowing that any investments your startup makes today will result in revenue that has less buying power at a future date.
In simple terms, discounted cash flow analysis is used to “discount” the potential return of an investment your company will make today and price it in “future dollars.”
One of the most challenging parts of discounted cash flow analysis is knowing what discount rate to use for your calculations. This includes discounting for the time value of money as well as for potential industry risks in the future, such as one of your largest clients being unable to pay for your products over a period of time.
When you take the time to calculate the net present value of all of your investments and use proper discounting, you can determine which investments are best for your startup.
Steps to Build a Financial Model for Your Startup
Now that you have a clear idea of what financial modeling entails, it’s time to begin developing your financial model from the ground up. We’re going to discuss the steps your startup should take to develop your model and ensure that you forecast your potential growth in the clearest and most accurate manner possible.
Generally, creating your financial model will involve determining your key performance indicators (KPIs), determining your revenue, using a financial template, getting projections, estimating additional expenses, and then reviewing all of your projections and verifying that all of your inputs are accurate.
Once you’ve created your financial model, you can begin to share this information with your internal team members, investors, and potential acquirers to give them confidence in your startup’s vision, goals, and future growth.
Step 1: Determine KPIs
The first step of creating your financial model is to determine the key performance indicators (KPIs) of your startup. Your KPIs are assumptions and numerical factors that you’re able to track directly, giving your business the ability to see performance over time.
Depending on your industry, there may be certain KPIs that are considered the most important or an “industry standard.” We recommend using all of the standard KPIs for your industry as a starting point and then adding additional KPIs as required if there are any additional factors that you wish to track.
Once you've determined your KPIs and gathered any current KPI data your startup has, you’ll begin using these KPIs to model and project your growth into the future.
Step 2: Determine Revenue
When building a financial model, it’s important that you start from the top of your income statement (revenue) and work your way down the list.
Consider all of your startup’s current sources of revenue, as well as how that revenue comes in. It’s absolutely critical that you understand what’s driving your startup’s revenue and if there are any particular customers or marketing activities that are driving rapid growth.
As you project your revenues, think about your cost of goods sold (COGS) and any inventory expenses that you may incur.
Determining and projecting revenues for your startup might take some time, including using data from adjacent industries or similar companies to validate your projections, but it is well worth it as you progress with your financial model.
Step 3: Use a Financial Template
Instead of starting from scratch and building your financial model from the ground up in a spreadsheet, you can save considerable time by using a financial template and adapting it to your startup.
There are a number of free templates available online for each type of financial model, and utilizing these templates is a great way to develop your financial model faster and ensure you don’t miss any key components.
Step 4: Get Projections
As your startup continues to grow, one of your most significant costs will likely be staffing and hiring employees, followed closely by marketing.
Think about how your company’s staffing needs will change as you grow in the future, and take all of the additional expenses related to employees into account. This includes considering salaries, recruiting and hiring costs, office space or equipment for remote work, and extra overhead that comes with hiring additional employees.
Once you’ve projected staffing needs, take some time to estimate future marketing costs and how much more marketing spend your startup will need to allocate in the future.
Depending on your conversion rates, average order value, and customer acquisition costs, all of these numbers will vary startup by startup. Take the time to look at all of your numbers and make the most accurate projections you can muster.
Step 5: Estimate Additional Expenses
At this point, you’ve looked at all of the major costs and projections associated with a standard financial model but likely haven’t taken additional expenses into account.
One of the best practices to estimate any additional expenses and verify that you aren’t missing any critical expenses that you may have overlooked is to look at other successful companies and see how they have grown and scaled their expenses over time.
If you’re in the same industry, chances are that your startup will experience similar spending as you grow.
Step 6: Review Projections
Congratulations, you’ve managed to work through all of your startups’ input variables and come up with a solid financial model and projections that can guide your company into the future!
As a final step, make sure to test your model. Carefully review all of your financial modeling, your projections, and your assumptions. Ask yourself, “Does this make sense? Is this realistic?” A final sanity check is always a great way to double-check your work and make sure your financial model is up to snuff.
Frequently Asked Questions
How do you create a financial model for a startup?
You can create a financial model for a startup by determining the key performance indicators (KPIs) of the startup company, modeling its revenue, using a financial template as a starting point, projecting your staffing and marketing costs, and estimating additional expenses based on other successful companies in your industry.
Aggregate all of this data and use the information you’ve gathered to project revenues, expenses, and growth into the future.
Where do I start in financial modeling?
The best place to start in financial modeling is to determine which type of financial model you want to develop.
One of the most common financial models is called the “three-statement model” and involves looking at a company’s balance sheet, cash flow statement, and income statement. Once all of this financial information has been gathered, whether from historical performance or external data sources, a financial model can be created to forecast revenue and expenses.
How do you evaluate startup finances?
The finances of a startup can be evaluated by looking at the company’s income statement, cash flow statement, and balance sheet. An income statement will show all of the revenue and expenses of the startup, the cash flow statement will detail money in compared to money out, and the balance sheet will show assets and liabilities.