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How to Create a Financial Model for a New Business: A Complete Guide
Forging ahead with a new business and no financial plan is like driving while blindfolded. Knowing how to create a financial model for a new business is one of the most essential skills for every entrepreneur to learn. It doesn’t matter if you want investment, you’re planning operations, or you simply want to see if your business idea makes sense financially, a solid financial model will be your beacon on the uncertain trek down the trail of entrepreneurship.
What Is a Financial Model and Why Your Business Needs One
Essentially, a financial model is a math-based reflection, or representation, of how your business runs, it takes your strategy, your assumptions, and your projections, and articulates them into fiscal numbers. Think of it as your business’s financial blueprint – it illustrates to you how the cash comes in and goes out of your business, and helps you see when you are likely to be profitable, and when and how much capital you need to raise on the way to profitability.
For new businesses, financial models add great value, serving a variety of purposes; they’re your operational budget, a way to communicate to potential investors, as well as a structure for working through strategic decisions. More importantly, they can show you potential issues before they become catastrophic, providing you with time to reconsider or modify your strategy.
The Core Benefits of Financial Modeling
Risk Management: Running a range of scenarios lets you prepare for multiple market states and understand how changing certain key variables will affect your business. This preparation ultimately prepares you to build resiliency into your business plan.
Investor Communication: Investors are looking for specific numbers reflecting your understanding of your business and on what a return may look like. A detailed financial model should demonstrate that you have thought through the details and can deliver your value proposition quantitatively.
Strategic Planning: Financial models are handy as you evaluate different growth strategies, pricing models, and operational decisions. They ultimately provide the quantitative basis for making choices about which alternative path forward is chosen.
The Three Important Financial Statements
As you learn how to build a financial model will you need to understand the three interconnected financial statements that form the basis for any strong model:
Income Statement (Profit & Loss): This reports your revenue, expenses, and profit over time. For new businesses, it shows whether your business will be financially sustainable by comparing revenue and costs as projecting into the future. It helps you figure out whether you can become profitable and assists you in finding opportunities to reduce costs.
Balance Sheet: This is a comparison of the value you have (asset) against the value you owe (liabilities) and the value that you own (equity) at a point in time. The balance sheet is extremely significant to a company’s understanding of its financial position and ability to meet obligations.
Cash Flow Statement: Possibly the most important statement for new businesses is a cash flow statement, which determines how cash flows through your business. Many profitable businesses fail due to cash flow problems, which is critical to understand for your survival.
Basics of Revenue Modeling
Market-Based Revenue Modeling: First, you will want to develop your projections based on your entire addressable market and then make a realistic estimate of how much of that market you actually think you’ll be able to capture. One common mistake is assuming you can capture even 1 percent of a truly large market without providing justification.
Customer Level Revenue Modeling: Develop your revenue projections from the customer level, including acquisition costs, lifetime value, and attrition. A bottom-up (rather than top-down) perspective will provide more realistic projections in your revenue modeling.
Multiple Revenue Streams: If your business has multiple revenue streams, model each of its multiple revenue streams so that you can understand how much you are contributing to the total revenue and how efficient each is at exponential growth.
Complete Expense Structure
Operating Fixed Expenses: Fixed operating expenses do not vary with your sales volume. Examples of fixed operating expenses include rent, insurance, employee salaries, to name a few. Understanding your fixed cost base is important for determining break-even.
Variable Costs: Variable costs change based on your business volume of sales, such as materials, production costs, and sales commissions. Understanding the proper procedures for modeling variable costs assists in understanding your contribution margins to overall profit and the way your business scales.
Working Capital Requirements: This represents the funds needed to operate your business as it relates to day-to-day operation. Working capital is calculated as current assets subtracted by current liabilities. Many entrepreneurs fail to understand their working capital needs or they underestimate their working capital needs. Not being aware of working capital needs is a primary cause of cash flow crises for many new businesses.
Step-by-Step Guide to Building Your Financial Model
Step 1: Understanding the Purpose of the Model and Timing
Before you begin building your model, take some time to be explicit on the purpose of the model. For instance, are you building it for purposes of internal planning, or for an investor, or maybe a loan application? Understanding why you are building it, will help you understand how complicated you need to make the model, and what you need to highlight in the model. Your new business model should project 3-5 years into the future, enough detail around the first year, and then more fluency of estimates in the future years.
Step 2: Set Realistic Assumptions
Make an assumptions section that guides your model: everything in your financial statements should come from these assumptions, making them easy to update and scenario test.
Market Research-Based: Set your assumptions on real market data rather than wishful thinking. Look for an industry standard, study competitors, and if possible, confirm assumptions with potential customers.
Operational Metrics: Choose key performance indicators based on your business model, including such metrics as cost of acquiring customers, conversion rate, average order value, and retention rate.
Financial Assumptions: Set your assumptions related to payment terms, working capital cycle, tax rate, and cost of financing. These “little” things can drastically and profoundly change the cash flow model.
Step 3: Construct Revenue Forecasting Models
Bottom-Up Revenue Modeling: Use individual customer or transaction data to begin creating models going up to total revenue. This practice will produce more credible revenue forecasts than general market assumptions.
Seasonality Considerations: If your business is seasonal, this should also be added to your monthly forecast and not assumed to be flat throughout the calendar.
Revenue Recognition: Make sure your model properly separates when revenue is recognized contrasted with when cash is received. This is most important for subscription businesses or when terms are delayed.
Step 4: Structure Your Cost Model
Personnel Planning: Build a thorough headcount plan that includes salaries, benefits, payroll taxes, and recruiting costs. When developing your hiring plan, use milestones related to the growth of the business, as opposed to a calendar date.
Operational Expenses: Include all the costs to operate your business from technology infrastructure to marketing expenses. Research and validate your assumptions based on typical cost structures for each of these expenses within your industry.
Capital Expenditure Planning: Identify the investments required in equipment, technology, and facilities. While the cash required will be significant in the near-term, the capital expenditures will be needed to facilitate growth.
Step 5: Incorporating Working Capital Dynamics
Model the timing differences of when you incur expenses and of when you collect revenue. This includes:
Accounts Receivable: You want to model expected collections based on your payment terms and your expectations about realistic collections.
Inventory: You want to model your inventory levels relative to your expected sales in the working capital requirements if there is inventory.
Accounts Payable: You want to incorporate the accounts payable detail on when you expect to pay suppliers and your cash management detail.
Step 6: Build Dynamic Financial Statements
Connect your three financial statements, so that they update automatically when assumptions change. In the income statement, link to the cash flow statement, and both should link to the balance sheet in a manner that is mathematically consistent.
Advanced Financial Modeling Techniques
Break-Even Analysis
Determine when your company will be profitable by using break-even analysis. The formula is straight forward:
Break-Even Point (Units) = Fixed Costs ÷ (Price per Unit – Variable Cost per Unit)
Break-even analysis determines the minimum performance levels that your business must achieve to be profitable. The analysis also helps to drive pricing decisions.
Scenario Planning and Sensitivity Analysis
Develop multiple scenarios to test how your business will perform under various circumstances. It is recommended to develop at least subdivided into:
Optimistic Scenario: the best-case assumptions related to growth and market expectations
Base Case Scenario: the most likely result using reasonable assumptions
Conservative Scenario: assumptions that are pessimistic and stress-test your model
This is an essential analysis to help understand the range of outcomes and plan for contingencies.
Cash Flow Administration
Forecast your cash flow: For, at least, the first year establish thorough, monthly cash flow forecasts. Many companies fail, not because their business is unprofitable, but because they run out of cash before their business becomes profitable.
Capital Requirement: Utilize your cash flow forecasts to plan when, and how much funding you will need. Do not wait until you run out of cash to raise money, plan to raise money before you need it.
Common Pitfalls to Avoid
Overly Optimistic Forecasts
Many entrepreneurs take the easy path and create “hockey stick” growth forecasts without a sound explanation. Use actual research and comparable model to make your assumptions, not hope.
Timing Cash Flow
Another common pitfall is focusing primarily on profitability and timing cash flow second, or not at all. Even a profitable business can fail if it is not managing cash flow.
Static Modeling
You’ve most likely seen or even created a set of static models that don’t update automatically as sound underlying assumptions are changed. Resist the urge to hard-code with numbers etc. These models are cumbersome to manage and unable to effectively scenario test.
Too Little Detail In Distant Future Looks.
While it is acceptable to take a broad view of financial forecasting beyond 5 years, the first-year projections must be much more detailed in a monthly format. This detailed projection can help with both operational and cash flow planning.
Leveraging Your Model for Decision Making
Investment Planning
Your financial model should clearly show funding needs on a time basis and expected return on investment. Use it to assist in determining when the best timing for fundraising, and to communicate value creation for stakeholders.
Operational Management
Your model can become a management tool if you are continually measuring actual results compared to your model projections (both accomplished results and projections are to inform management on areas of improvement).
Strategic Evaluation
Financial models can quantify the impact from a strategic choice such as entering a new market, launching a new product or changing operations. They can support criteria for evaluating opportunities objectively.
Tools and Resources for Financial Modeling
Spreadsheet-Based Solutions
Most entrepreneurs begin with Excel or Google Sheets because of their flexibility and availability. There are many options of free templates available to help you get started.
Specialized Software
Once your business scales, it is worth thinking about financial planning software that will offer superior scenario management and real-time collaboration.
Professional Support
For more complex businesses or during more substantial funding rounds, you may want to think about using financial professionals who work in your industry and have experience doing modeling.
Keeping Your Model Relevant and Updated
Regular Model Reviews and Updates
Monthly Actual vs. Projected: Each month, review how actuals compared to projections and what may have driven any variances. This should help frame your assumptions and possibly improve projections in the future.
Modify Assumptions: As you receive data regarding the business, adapt assumptions for reality. Your model should change as you learn about the business.
Scenario Revisions: Revise the scenarios of your model regularly as market conditions change (e.g., what was once considered an optimistic scenario of sixty days ago, may now be your base case scenario to consider).
Model Documentation
Evidence of Assumptions: Document all evidence of your assumptions, and communicate rationales if there are assumptions. You want to be able to lift facts with realism and provide clarification details with the updates to the process.
Version Control: Maintain transcript for changes, clear document and changes log for and document of version control. Financial Model revise, revise, and renot revise. Therefore, it is important to document change and change control for clarity on what has change, which change has been monitor and how it may affect results.
Essential Performance Measurement Metrics
Financial Metrics
Gross Margin: Revenue generated by the business minus the cost of goods sold expressed as a percentage of revenue. This metric illustrates the profitability of your core business and excludes overhead.
Cash Burn Rate: How much cash you are spending every month above what you are generating. This metric is essential for understanding how long your funding will last.
Customer Metrics: Metrics that measure customer acquisition cost, lifetime value, and churn rates. These metrics are critical for long-term sustainability of the business.
Operational Metrics
Revenue Growth Rate: The month over month and year to year growth rates. Consistent growth rates affirm your assumptions about the market with the growth metrics you are analyzing.
Working Capital Efficiency: How effectively you are managing the cash conversion cycle. Enhanced management of working capital can greatly impact cash flow.
Final thoughts
Understanding how to build a financial model for your new business is an investment in its success. A well-structured model is your north star when you encounter the challenges of building a viable business. It provides the data underpinning your decisions, support for investment, and safeguards against common missteps that bring down so many businesses.
It is also important to keep in mind that financial modelling is not a concept for a single exercise, but a process, changing as the business does. Start with a simple, moderate model, and then build complexity as your knowledge improves. When planning the model, focus on building one that you would use for strategy decision making – not a sophisticated one that merely looks good.
The time and anguish spent working towards a strong financial model will pay back over and over again, throughout your entrepreneurship journey. It takes your ideas of business and turns them into concrete critical paths for success. Then it provides the analysis needed to build a successful sustainable business, whether you need capital to fund growth, need to plan the operation of your business, or simply need to understand what your business can be one day. Your financial model is your most valuable asset in turning entrepreneurial vision into financial reality.
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