All budding entrepreneurs spend long hours typing up a well versed strategy document for their new entity, as expected. However, very often there is insufficient time allocated to the crux of the business, the numbers.
Definition: Financial modelling is the process by which a firm constructs a financial representation of some, or all, aspects of its business.
For any new start-up entity the initial necessity for assessing potential returns on new investment or seeking external funding can be a daunting process. Whether you are soliciting funds from an institution, or a high net worth individual investor, the financial projections could make or break your deal.
Although you as the founder are naturally optimistic about the new venture, be mindful that most investors would rather see the worst case scenario. This allows the potential investor/banker to take a realistic view on the maximum potential losses, should the business fold in the first 12 – 24 months. As such, it is recommended to produce a low, middle and high road model, for a three to five year period.
Inputs and outputs
Most importantly, always keep in mind that your financial model is nothing more than certain inputs producing certain outputs. By designing the model correctly, a user should be able to change certain inputs to assess the impact of these changes on the related outputs (commonly referred to as a ‘what if analysis’ or ‘stress testing’ a model).
By way of a simple example, your sales revenue line for any specific month should be a function of the number of products sold, at a specific sales price.
For ease of use, both you and a potential investor should be able to adjust either of these variables in order to see how resilient the business model is, should your assumptions be incorrect.
Other basic recommendations when building your model:
- Create an assumption page, clearly defining any assumptions on which the model is built. By linking certain variables to the assumption page the model becomes robust and user-friendly.
- Be as transparent as possible, showing all formulae that lie behind calculations. This allows the user to easily follow logic through the model.
- Aim for simplicity and ease of understanding. Over-complicating a financial model with unnecessary worksheets can confuse and overload the reader.
- When inputting projected overheads, deal with each line item separately, without consolidating. This demonstrates detailed thinking, and allows discussion around each expense if necessary.
- The model should evolve with the business. You should be looking to check the assumptions made at the inception of the business, with the reality of what is achievable, after having the benefit of hindsight. By tweaking the numbers accordingly, the model becomes a more accurate prediction of the business in the future. This should be an ongoing process.
- Beware of attempting to use a generic template that may not apply to your business. Trying to customise these generic models could complicate a would-be simple model. Building your own bespoke model from scratch is the cleanest approach, even if assistance is necessary. This forces you to learn the intricacies of your model, which will hopefully stand you in good stead.
- Many books and websites recommend a myriad of options when it comes to building financial models. As a principle, lean towards the concept of simplicity, provided you are able to integrate your model into regular projected income statement, balance sheet and cash flow statements.