All startups need to build a sustainable financial future to succeed in the long term, and a financial model is critical to accomplish this goal. Founders may take the casual approach to budgeting when they start, as it’s difficult to project cash flow in the next few years. However, a financial model works to focus your business direction and not to project findings accurately.
Why Does a Startup Need a Financial Model?
Almost all companies perform some form of financial planning or budgeting, but the specific reasons you’re adding a startup financial model to your company can provide direction.
- Creating an Economically Viable Business: A business plan can help you determine if your ideas, assumptions, or visuals are sustainable or make a positive impact.
- Drafting a Complete Fundraising Profile: Banks, angel investors, or subsidy providers will want a document showing your financial model to ease them into the investment.
- Informing Shareholders: Without targets to achieve, your shareholders won’t know how your business is operating or where your money is being spent within the company.
Top-Down or Bottom-Up Forecasting: What’s the Difference?
It’s easy to determine that you need a financial model, but the real issue is how to get the metrics you need to form a usable model. Enter top-down and bottom-up forecasting.
Top-down forecasting starts with the business assessing the entire market. Most companies will start with their current market size then factor in sales trends. By the end, a top-down approach will estimate what percentage of the market will buy your services.
- Pros: Reduced variability and faster results.
- Helps a business amplify their strengths and remedy weaknesses.
- Works best for startups, companies seeking funding, and firms with consistent profits.
Bottom-up forecasting has a basis in the product or service the company offers, which forms a projection based on what you need to get from the market. It’s less dependent on external factors but uses internal company data (sales data) to build towards a micro view.
- Pros: Realistic financial view, better item forecasting, greater employee involvement.
- Helps companies examine specific expenses and relay sales projections and capacity.
- Works best for startups for budgeting and hiring and for seasonal businesses.
What Are the Outcomes of a Financial Model?
A good financial model will have three key outputs regardless of your unique business needs.
- Financial Statements: Financial statements like profit and loss, balance sheets, and cash flow are the best ways to communicate performance to yourself and others.
- Operational Cash Flow: A monthly cash flow overview can track actual performance based on your expected budget and can help you track growth potential.
- Key Performance Indicators (KPI): Your KPIs are the most important metric your business tracks. These metrics can help you scale and become more profitable.
What Are the Inputs of a Financial Model?
The outcomes of a model work with different inputs that determine how well your company is performing. There are 6 common inputs and 4 extra, but essential, supporting elements.
- Cost of Goods/Services Sold: Per unit cost, materials, and labor.
- Revenues: Forecasting revenue using a top-down or bottom-up method.
- Personnel: Split further into labor, sales/marketing, research, and administration.
- Operating Expenses: Expenses incurred from running the business.
- Financing: Loans, equity, subsidies, or direct funding.
- Asset Investments: Funds used to buy or upgrade property, equipment, or buildings.
If you need to tweak some numbers for your financial model, these four elements may help.
- Working Capital: Money needed to sustain daily operations
- Taxes: Adding taxes to items can help you lower what you pay to the IRS.
- Depreciation: Value reduction of what your business owns, like computers.
- Valuation: Estimating the cost of an asset, firm, or business.
Keep in mind that if sales don’t ramp up as expected, it’s likely your financial model and business plan don’t match. Experiment with different models to see the results you want.