If you have a startup and you want to build a sustainable financial future, you’ll need to regularly create and rely upon financial models to guide your decision-making for the startup. This guide answers the what, whys, and hows of financial modelling. A financial model can help you determine the profitability of your business, identify areas to optimize costs, and help you arrive at other important financial decisions for your startup.
Most financial models are built on MS Excel and require considerable expertise in creating formulas and analyzing data in the software. This guide will help you with the broad framework of how to get started with building your financial model.If you’re ready to take informed decisions for your startup by building financial models, keep reading!
What is a financial model?
A financial model builds an abstract representation of a real-world financial situation. Using mathematical modelling, the performance of a financial asset, portfolio, business, or any other investment is represented in a simplified version. Commonly, financial models take into account cash flow levels, rate of inflation, inventory levels, among other mathematical representations to create a forecast as to the performance of the company or investment.
Such models are intended to be used as decision-making tools. Company executives might use them to estimate the costs and project the profits of a proposed new project.
Financial analysts use them to explain or anticipate the impact of events on a company’s stock, from internal factors, such as a change of strategy or business model to external factors such as a change in economic policy or regulation.
Financial models are used to estimate the valuation of a business or to compare businesses to their peers in the industry. They also are used in strategic planning to test various scenarios, calculate the cost of new projects, decide on budgets, and allocate corporate resources.
Types of Financial models
There are various types of financial models. However, they can be fit into three-broad categories: Project finance models, integrated financial statement models, and pricing models.
Project finance models
When a sizable infrastructure project is being evaluated for feasibility, the project finance model helps determine the capital and structure of the project. Project finance is only possible when the project is capable of producing enough cash to cover all operating and debt-servicing expenses over the whole tenor of the debt.
Loans and the associated debt repayments are an imperative part of project finance models, since these projects are normally long term, and lenders need to be sure if the project can bring sufficient cash against the debt. In other words, project finance models are used as financial models when the company needs to assess the economic feasibility of the project.
Integrated financial statement model
The integrated financial statement model is one of the most basic types of financial models. It usually takes the most important financial statements of a business -for example, income statement, cash flow statement, and balance sheet, and combines them to generate insights as to the performance of the company. The integrated financial statements model is used across multiple contexts, such as due diligence for M&As, research for private equity investment. Given its versatility, it can also be used to gauge the financial health of a company and is considered a general indicator of performance.
This category of financial models is built for the idea of establishing the price that can or should be charged for a product. The input to a pricing model is the price, and the output is the profitability. To create a pricing model through financial modelling, an income statement, or profit-and-loss statement of the business or product should be created first, based on the current price or a price that has been input as a placeholder. Once this has been determined, the model uses the cost statements to determine the overall profitability of the product or service. Thereby creating an estimate as to the ideal pricing strategy to be adopted for the product or service.
Why build a financial model? – Benefits & uses
Better understanding your business
A financial model is developed after having a deep insight into the business. The analysts understand how a business operates and what are the different factors that could impact such business. The businesses are also required to understand what changes are expected to take place in a scenario when there are changes in the internal as well as external environment of the business. Thus, companies that develop financial models can understand their business as well as the factors affecting them better than their competitors and are therefore better prepared for any uncertain situation.
Periodic Review of Performance
To understand how a business is performing, it is important to do a variance analysis. Financial models help in carrying out the variance analysis by comparing the actual results of the business against the budgets. The performance review can be done periodically to get feedback on the business operations. Some advanced financial models help businesses to carry out adjustments in their operations based on the variance analysis so that overall profits can be improved.
Decide the Fund Requirement & Strategy
Financial models provide clarity on the expected cash inflows and outflows. A business can get to know the net cash flows that it would be required to arrange to run its affairs. The next step is to decide the source of funding, i.e. debt vs equity. For this, the financial models help in understanding what would be the cash flow position after meeting the interest expense and repayment of loans. This helps to decide whether and to what extent the business can take debt and what shall be the level of equity financing.
Companies that wish to determine their monetary worth can use financial models. A financial model helps in determining free cash flows that are expected to accrue to a business at different points of time which further helps in reaching the fair value of a business. This becomes useful for businesses when making any restructuring, such as when selling the stake to the outsider parties and investors.
Since a financial model helps in carrying out due diligence by suggesting the financial impact of a particular activity, thus, it helps the businesses in minimizing the overall risk in a business. For example, suppose a business wants to enter the new market; a financial model would guide the business regarding the cost of such entrance, the effect of marketing, price changes, and so on.
Businesses may take months to get answers to certain financial questions and to determine the impact of a certain decision. However, financial models are quick in giving results which helps in quick decision-making. In such a way, financial models become very useful for businesses.
Accurate Financial Budgets and Forecasts
Financial models build financial budgets and forecasts based on business data and thus, tends to be accurate. Businesses can use these budgets and forecasts for their business activities so that their activities remain structured and within the defined structure. Not following any budget or business strategy can be harmful to the businesses.
Helps in Business Growth
Financial models help a business to grow by suggesting the areas that are capable of generating higher profits. The models also help in carrying out a cost-benefit analysis of new projects. Businesses can use financial models to understand as investment shall be made in which areas and projects for better profitability and growth.
Steps before building a financial model
Identify actual need
The first step before building a financial model is to determine the kind of forecast that is required. For example, if you’re looking to expand, and want to understand how to allocate spending between Marketing and other departments, then the kind of forecasts that are typically required would differ, from when you want to develop a pricing strategy for a particular product or service you’re offering. Thus, determining the requirement is the crucial first step to building any effective financial model.
Collect data about the company/asset/investment
The second step is to collect data about the company or more generally, the subject of the financial model (potential investment or existing asset, etc.). This data may be sourced from publicly available sources such as the company’s website, published annual reports, or through internal sources from the company itself, such as internal audited statements. The data to be collected would also depend on the type of forecast required. For example, the three-statement financial model only requires the income statement, cash-flow statement and balance sheet.
Understand the Industry Dynamics
The next step is to read and understand the industry dynamics from industry analyses reports. It is required to first determine the right industry of your company as a majority of the companies function as per their industry dynamics. It is equally important to completely understand the industry dynamics, since the performance of a company is also dependent on the factors affecting the performance of the industry/sector. Industry analyses reports are usually published by thinktanks, or government agencies or consulting firms such as Deloitte, PWC.
Once you have identified the need, that the financial model will be addressing, gathered sufficient data about the company and the industry, you can start building the actual financial model itself.
Building the financial model
Start with the audited financial statements
The data collected about the company will form the primary basis of the financial model. It is recommended to incorporate the audited statements for the last 3-4 years since it will provide a more comprehensive picture about the overall financial health of the company.
Outline the assumptions
Using the data of the company, the next step is to calculate the past ratios like Revenue Growth, Expenses to a percentage of Revenue, Gross Profit Margin, EBITD Margin, Working Capital Days etc. Based on the calculation, you are required to forecast the same ratios for future years to calculate the forecasted numbers.
For Example; if your company has grown by a Revenue Compounded Annual Growth Rate) of 20% for last 3 years and the Industry is also growing by the same rate for future years, then you can also assume the same growth rate of Revenue for next 2-3 years.
Assumptions can also be made based on the industry numbers, but must factor in the size of the company. For instance, a new startup has increased needs in marketing and thus should not directly use the average spending of a few big, mature companies in the sector without accounting for the size of the startup.
Prepare the forecasts
Preparing the forecasts is the process where the inputs are put through a series of mathematical operations to arrive at the necessary outputs that were required. Usual forecasts include Profit & Loss projections, that account for depreciation, cost of finance, taxes, and the past revenues of the company. To provide another example, in order to undertake a risk analysis of an asset, the assets and liabilities of a company are used to calculate debt and debt-equity ratios that forecast the liquidity of the company vis a vis its assets and liabilities. Interest coverage ratio for example, indicates the number of times a company can pay its interest with the current earnings before interest and taxes of the company and is helpful in determining the liquidity position of the company by calculating how easily the company can pay interest on its outstanding debt.
Validating assumptions & outputs
Validation of assumption in a financial model is a process where the modeler seeks proof or verification from the source of the assumption which is recorded. This is a crucial step in building a financial model since it links the speculative nature of the model and the forecasts, to the status quo.
First, the modeler collects and organizes the assumptions and then sends them back to the original provider of the information. The provider should then confirm that the information now in the assumptions is valid and can be used in the model. By acquiring this information from the assumption owner, the modeler can subsequently make a more informed opinion on the assumption and start to validate.
Best Practices and other general tips
- When building a financial model, do check for several scenarios of the model ranging from best-case to worst case. This will help you account for different possibilities and be equipped with the best course of action to adopt if things don’t go according to the forecasts.
- We mentioned earlier that an in-depth knowledge of MS Excel might be necessary in order to build a financial model. There are other alternatives including various softwares that have ready-made formulas to help generate your forecasts and outputs, which might be worth checking out if you are not as comfortable with using MS Excel. However, since each financial model is different, it is always recommended to build your models from scratch.
We have discussed various examples and types of financial models, to help provide a holistic guide for you. However, the financial model you build will be tailored according to the needs of your startup, and no two financial models are the same. We hope this guide equipped you with the basic know-hows of financial modelling and the various factors that need to be considered when building a financial model. With the information we have shared we hope you are well-positioned to start forecasting, maybe even build your own financial model and make sense out of the metrics and data that are presented by your model!