Financial Modeling & Types of Financial Models

What Is Financial Modeling?

Financial modeling is the process of creating a summary of a company's expenses and earnings in the form of a spreadsheet that can be used to calculate the impact of a future event or decision. A financial model has many uses for company executives. Financial analysts most often use it to analyze and anticipate how a company's stock performance might be affected by future events or executive decisions.

KEY TAKEAWAYS

• Financial modeling is a representation in numbers of some or all aspects of a company's operations.
• Financial models are used to estimate the valuation of a business or to compare businesses to their peers in the industry.
• Various models exist that may produce different results. A model is also only as good as the inputs and assumptions that go into it.

The Basics of Financial Modeling

Financial modeling is a representation in numbers of a company's operations in the past, present, and the forecasted future. 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. Examples of financial models may include discounted cash flow analysis, sensitivity analysis, or in-depth appraisal.

Real-World Example

The best financial models provide users with a set of basic assumptions. For example, one commonly forecasted line item is sales growth. Sales growth is recorded as the increase (or decrease) in gross in the most recent quarter compared to the previous quarter. These are the only two inputs a financial model needs to calculate sales growth. The financial modeler creates one cell for the prior year's sales, cell A, and one cell for the current year's sales, cell B. The third cell, cell C, is used for a formula that divides the difference between cell A and B by cell A. This is the growth formula. Cell C, the formula, is hard-coded into the model. Cells A and B are input cells that can be changed by the user. In this case, the purpose of the model is to estimate sales growth if a certain action is taken or a possible event occurs. Of course, this is just one real-world example of financial modeling. Ultimately, a stock analyst is interested in potential growth. Any factor that affects, or might affect, that growth can be modeled. Also, comparisons among companies are important in concluding a stock. Multiple models help an investor decide among various competitors in an industry.

Three reasons for having a financial model as a startup

Before we dive into the technicalities and different elements of a startup’s financial model we are going to broaden our view a bit and address why forecasting in general is an important topic for startups. Almost all companies perform some kind of financial planning or budgeting, but there are particular reasons why a financial plan is important for startups specifically:

1. You need one to build an economically viable business. Why? Because by quantifying (and then validating) your business plan and business model, assumptions and vision you are able of finding out whether you can turn your ideas into a sustainably operating business. Moreover, if you build different versions (“scenarios”) you are better prepared for the future, especially if things do not go the way you planned. What if you launch half a year later? Answering such a question in your “worst case scenario” helps you anticipate how your cash flow, profitability and funding need are impacted.
2. You need one as part of the fundraising process. Financiers will typically ask you for a financial plan when you engage with them to raise funding, whether them being angel investor, VC, bank or subsidy provider. Certain investors will require more details then other, but building a model is wise even if you only need to provide them with high-level data. Why? Because it helps you answer the tricky questions a financier might have when he or she dives into your business case. Moreover, how are you planning to raise funding if you did not properly calculate how much funding you actually need?
3. You need one to inform yourself and shareholders. How do you know how your company is doing if you don’t have any targets to achieve or steering information to compare against? How are you going to update your shareholders on how you are spending their money and whether you are performing as promised without any financial plan to benchmark against? You will need a forecast to do so.

Two different approaches to financial modelling for startups

There are two main methods to answer these questions: top down forecasting and bottom up forecasting.

Top down forecasting

Using the top down approach you work from a macro/outside-in perspective towards a micro view. Typically industry estimates are taken as starting point and narrowed down into targets that are fit for your company. In essence the top down method helps you to define a forecast based on the market share you would like to capture within a reasonable timeframe. A useful aid to perform top down forecasting is the TAM SAM SOM model. The TAM SAM SOM model captures the market size on three levels: the total worldwide market for a product or service (TAM: total available market), the part of that market you address with your specific offering (the niche market) adjusted for your geographical reach (SAM: serviceable available market), and the part of SAM you can actually realistically capture (SOM: serviceable obtainable market), given the existing competition. SOM is therefore equal to your sales target as it represents the value of the market share you aim to capture.

Bottom up forecasting

The pitfall of the top down approach is that it might seduce you to forecast too optimistically (especially sales). Often entrepreneurs calculate SOM (equal to sales) by taking a random percentage of the market, without really assessing whether this target is realistically achievable. A tiny percentage of a market might seem insignificant, but could be way too optimistic for instance in the year of your launch. Therefore, it could be useful to complement the top down method with the bottom up approach. The bottom up approach is less dependent on external factors (the market), but leverages internal company specific data such as sales data or your company’s internal capacity. Contrary to the top down method, the bottom up approach begins with a micro/inside-out view and builds towards a macro view. This means a projection is made based on the main value drivers of your business. Short example: let’s assume one of the main drivers of an online SaaS business is online marketing. One of its online marketing tactics is to advertise its product via LinkedIn. The company could define the costs per click using LinkedIn’s advertising tool, estimate the number of website visitors it will attract as a result, the conversion from website visitor to a lead, and the conversion from lead to customer. Based on these metrics the company will have a good idea of potential sales, of course constrained by the budget available for online advertising. Performing a bottom up analysis therefore does not only force you to think about what are realistic targets for your company, but also to think about the ways in which you will spend your resources. With the bottom up approach, you estimate revenues, costs, expenses and investments in the same way as described above: based on the resources at hand and the company data that is available. The pitfall of the bottom up method though is that it might fail to show the optimism needed to convince others of the potential of your company.

If you are a startup founder and you are looking to raise funding, the bottom up approach might not do the trick. Investors usually expect startups to grow fast and gain significant market share rapidly. The bottom up method might fail to reflect that. It is difficult to create a forecast with a steep growth curve if every sale has to be rationalized and if its point of departure is the maximal capacity of your company (or budget for advertising purposes). With the bottom up approach it is hard to take into account factors such as virality or word of mouth. Moreover, the whole reason why external financing is needed, is often to expand capacity and grow faster than a company would do organically.

Assumptions

No matter what approach you use to build your startup’s financial model, it is crucial you are able of substantiating your numbers with assumptions. As a startup, historic data is often not available so you need to be able to present the ‘proof’ behind your numbers. This will also help you when you start discussing with investors, as they are typically interested in knowing the reasoning behind your numbers. They are considering to put money in your company, so you do not want to give them the feeling you are selling baloney! Assumptions can be anything that validate your numbers: market research, web search volume, contracts with suppliers, pricing validation, historic sales, conversion rates, bills of materials, website traffic, etc. It could be useful to create a “data room” (e.g. a Drive folder) in which you collect these kinds of evidence. By doing so, you are slowly building a library that underpins all the numbers you have put in your model and you are well prepared in case an investor might request a due diligence process.

Three outcomes of a startup’s financial model

Every sector, company, business owner and investor is different. All of them have their own interests and all of them value different metrics. From that perspective it is thus fair to say every financial model has its own characteristics. Therefore it is possible to customize every model to its user.

1. Financial statements

Any decent financial model includes a forecast of the three financial statements: the profit and loss statement (P&L), the balance sheet (BS) and the cash flow statement (CF). The financial statements are the generally accepted way of communicating financial information across companies, banks, investors, governments and basically anyone that needs to show and/or understand financial performance in some way. Since any financial professional is able of interpreting financial statements having a forecast of them in place is typically a requirement in practically any fundraising process. The profit and loss (or income) statement is basically an overview of all the income and costs your company has generated over a specific period of time and shows you whether you are profitable or not.

2. Operational cash flow overview

For fundraising purposes a forecast of the financial statements is typically shown on a yearly basis. Monthly overviews are in most cases not really needed, because for early-stage startups it is more about showing the long term growth potential than about giving an insight in monthly operations. However, for the actual day to day financial management of your company it is useful to include an operational cash flow for the coming 12 months ahead in your financial model. Why? Because it addresses questions yearly financial statements cannot answer, for instance about the timing of cash in and outflows. This is important to anticipate (see section ‘Working Capital’ below).

3. KPI overview

The outputs of a startup’s financial model typically also include some company and/or sector specific KPIs (key performance indicators). As the name already implies KPIs are crucial metrics for your business. KPIs do not only matter for an investor, but also for you as a company owner. Based on these metrics you track the performance of your company, experiment with different acquisition channels, business models and cost structures, and you use them to make you and your co-founders laser-focused on the targets you defined. There are KPIs that show sales and profitability performance (such as revenue growth rate, gross margin, EBITDA margin or profits), KPIs related to cash flow and raising investment (such as the burn rate, runway and funding need breakdown) and company or industry specific KPIs.

Courtesy: Best financial modeling in Saudi Arabia