Reaching informed decision-making is the first step to building a lasting company. Without a sound financial model, you make decisions based on your gut instinct and anecdotal evidence.
You don't want that. Do you?
A financial model provides quantitative data to support any financial decision you make. Your team can make informed decisions about your long-term strategy with solid numbers.
It should be the foundation for any company’s analytics team and a source of truth for the company.
Here, we'll discover the importance of a financial model for a startup, its main parts and how you can prepare one for your startup.
What’s a Financial Model and Why Is It Important?
A financial model expresses your revenue, expenses and goals in a numerical form. It helps you validate product-market fit, identify growth opportunities, and plan for the long-term goals.
That's pretty dry, but what you should know is that a financial model helps you make better business decisions. It does this by providing data to help you understand your assumptions when trying to close funding rounds.
Before you even start raising money, a financial model will help your team assess the viability of an idea, figure out how much money you need to execute it, and identify key metrics to communicate the health of your business to potential investors.
You're a startup. You need investors. A financial model helps get them for you. It doesn't get any more straightforward than that.
A financial model can also provide a framework for sustainable product-led growth. Since PLG is a thing, and it's the kind of thing investors like, a financial model can make you look like a rock star — not in photographs, but on paper... and really only if rock stars had fiduciary responsibility; (they can't all be Dave Grohl).
In a startup financial model, your financial projections may not be exact. The difference between your projections and your reality provides valuable insights into your company’s potential, which can help you make important business decisions.
What Are the Key Elements of a Financial Model?
A financial model allows you to account for your company’s revenue and expenses. It helps you keep track and better understand your company's performance.
Let's have a look at the pieces:
COGS
Cost of Goods Sold (COGS) is the direct cost (material, inventory, and labor) incurred in the production of goods or services. It includes the cost of manufacturing, raw materials, packaging, distribution, sales, marketing, etc.
Your COGS depends on your industry.
Operating Expenses (OPEX)
Businesses incur operating expenses as part of their normal business operations. This is also known as selling, general, and administrative expenses (SG&A).
Operating costs are not directly associated with the production of goods and services but are necessary to run any business. These include rent, salaries of employees not directly involved in production, inventory, travel, marketing, etc.
Operating costs differ from one company to other. In a SaaS company, you might need to hire a support team, for example.
When forecasting your operational expenses, you might not know your future expenses, so consider setting aside a percentage of your revenue for this. A strong financial model can help you figure out how much.
Revenue
Revenue is the total income generated by the sales of goods and services.
The goal of a financial model is not to produce a pretty picture but to provide the right information to make meaningful decisions.
You can run a business with zero revenue if you have sufficient cash flow, especially if you're a startup.
Revenue doesn't just happen; a financial model helps you see opportunities to discover it. To bring in revenue, you need to understand your metrics, costs, revenue profiles, and the market you’re planning to serve.
You can forecast revenue:
- List your products or services.
- Decide the area you want to present your sales.
- Based on your analysis of the market, forecast sales per unit.
- Decide the selling price.
Forecasting revenue is industry-dependent, and you need to change it depending on your business. For example, in a SaaS company, forecasting revenue will rely on things like existing customers, new customers, CAC, and customer churn rate.
Working Capital and CAPEX
Capital expenditure (CAPEX) is the amount your company invests in physical assets such as property, intellectual property, buildings, or equipment. It represents the out-of-pocket expenses to purchase assets, such as office furniture, machinery, or land. When examining a company’s financial model, analysts often look at the CAPEX portion of a company’s expenses.
Working capital is the difference between your company's current assets (like cash and inventory) and its current liabilities (like bills and bank loans). In other words, working capital measures your company's liquidity. It shows how much money is available to run your business.
The higher the working capital ratio, the more assets a company has to generate future revenue.
For SaaS businesses, the costs of buying and maintaining their assets are typically limited. Some SaaS companies use customer relationship management (CRM) tools and need to buy a license for each customer, which can add up over the years.
For eCommerce companies, their CAPEX can influence their working capital, and thus it plays a critical role.
Financing
Financing accounts for all your external funds like equity, loans, or subsidies. It helps track your funding needs when you add different types of funding over the years.
When you raise funds as loans, account for their repayment with interest payments.
How to Build a Financial Model for a Startup?
There're several financial model templates on the internet. You can choose from those templates or develop one for yourself.
Here are some steps that can help you create your financial model.
Determine your goal
Do you want a simple financial model or a more detailed, granular model? Depending on your goal, you can decide which type of model to choose.
If you're market sizing or want a rough estimate, a simpler financial model is often better.
You need a more detailed financial model to present to VCs during funding rounds. It makes your conversations much more credible.
Finally, if you have an operating business, you'll need to develop a complex cash flow model for detailed analysis.
Find your KPIs
A Key Performance Indicator (KPI) is a measure that demonstrates how efficiently your company is achieving its objectives. You can start with industry-standard KPIs if you aren't sure what your company's KPIs should be.
Choose a template
Choose a financial model template that suits you; building one yourself is a time-consuming bandwidth sucker.
Enter actual results
Enter your actual results and merge them with your projections. You're unlikely to get a perfect match. If your actual results meet your projections, it probably indicates there's something wrong with your model.
Start with your revenue
Always start with your revenue. Understand the driving force responsible for your revenue. You should also consider COGS and OPEX.
Some companies take time to generate revenue. In such cases, you want to analyze and estimate the effort you need to put in to reach your milestones.
Calculate headcount expenses
Headcount expenses depend on your specific industry. You want to assess how many people you need to hire and how much each will cost.
And don't forget about recruiting costs.
Estimate other expenses
Look for examples from other companies to understand how they scale their expenses. As your company grows, include these estimated additional expenses.
Determine your working capital
Understanding your working capital is crucial. It’s the difference between being able to meet your debt obligations and falling behind on them.
Review your projections
Review your summary. Does it make sense? Do your projections meet your objectives?
How to Use a Financial Model Template?
If you're planning on using a financial model template, you can download one that best suits your business model and enter your data. Most templates are provided for free and updated regularly to reflect the most recent changes to your company.
Here's how you can use Chargebee's SaaS financial model template.
As you can see, a ready-made financial model template is much easier to use than creating one for yourself.
The benefits of using a financial model template are:
- Saves time
- Provides better design and structure
- Provides better insights
- Makes business presentation and communications easy
Conclusion
To be successful at a startup, you need to set objectives, then execute dynamically to reach that goal. A financial model helps you analyze your company's performance against its goals, allowing you to take corrective action.
By understanding the financial model and creating one, you can track your company's performance and drive it to reach your goals. You can bring in revenue by preventing and monitoring unnecessary expenses. A financial model helps you measure the health of your company, which helps you make better decisions.
