This article is about the importance of financial modeling for startups and small businesses.
When you own a company, managing your finances can be difficult without the right tools and knowledge. With a lot of uncertainty these days, understanding the financial outlook of your company in different scenarios is critical to the survival of your company. Forecasting can be a great tool at your organization’s disposal.
To build a financially stable business, for example, you must understand how the price of your product affects profitability, or whether a different cost structure will increase or decrease your profitability.
In other words, accurate financial modeling is required and necessary to help build your company and ensure that you that your growth and expectations for growth are in alignment.
What is Financial Modeling?
Financial modeling is the process of making financial projections and forecasting earnings and expenses based on past performance, expenses, and revenue assumptions.
The idea of financial modeling is to first define the different components of your business. Then, you can test each of these components against different scenarios. After you’ve designed the different scenarios and events, you can plan on how you’d handle different events.
Your financial model should be able to handle these different scenarios and calculate the business impact of these different extraordinary events.
Before creating your financial model, you should consider a wide range of details, such as how the model should reflect your company’s goals so that you can create a format that addresses all relevant financial aspects of your business.
Building a solid financial model takes time and effort, as well as extensive knowledge of several technical and non-technical skills. That being said, anyone can do financial modeling with the right education and knowledge.
Why Startups and Small Businesses Need Financial Modeling
There are three reasons why startups and small businesses need financial modeling: fundraising, building a business plan and gaining detailed knowledge of your business.
1. Fundraising
Raising funds is an important process that ensures the availability of working capital needed in your business’s day-to-day operations. Additional advantages of funding for your business include the necessary monetary support to test ideas and develop concepts, as well as the support of marketing and promotional activities.
A financial model is a standard requirement for any company seeking to raise funds. Financiers and investors will typically request a detailed financial report before funding your business, so developing a model to provide them with high-level data is prudent.
Put another way, if you don’t know how much money your company requires, then how are you going to put together a fundraising pitch?
2. Business Planning
To determine your company’s economic viability, you must quantify your business plan and validate your assumptions and ideas to see if they can be turned into a profitable business. The truth is that understanding all of this requires a solid financial model.
Your financial model will not only help you plan for the future, particularly when things don’t go as planned, but it will also predict how the worst-case scenario will affect your cash flow, funding, and profitability.
The model will account for a variety of scenarios, such as underperformance, hiring new talent, increasing revenue, and marketing spending, all of which can be critical to your company’s survival and scaled growth.
3. Gaining Detailed Knowledge of Your Business
A financial model accounts for likely changes in business conditions, allowing you to be better prepared for unexpected events.
It will also demonstrate to lenders and investors that you have a concrete plan in place for what it will take to remain successful in the face of adverse or unexpected circumstances.
They will also be able to use the information provided by your financial model to establish benchmarks for your business, as well as gain insights into how you are spending their money and whether you are performing as promised.
Types of Financial Modeling
Startups frequently face the challenge of determining what data to use as the foundation of their financial models because they have little to no sales history or metrics on customer satisfaction.
Fortunately, there are a lot of different templates available online. So, luckily for you, as long as you have someone in your team familiar with Excel, creating one will be simple.
Below are 5 types of financial models that you can use to help you model and forecast in your business.
1. Three-statement model
The three-statement model is the most fundamental financial model, intending to connect all the accounts and a set of assumptions that can drive changes in the entire model.
2. Discounted Cash Flow (DCF) Model
The DCF model values a business based on the Net Present Value (NPV) of its future cash flows. It takes the cash flows from the three-statement model, makes any necessary adjustments, and then discounts the cash flows back to today at the company’s Weighted Average Cost of Capital.
3. Budget Model
This model is designed for financial planning and analysis (FP&A) professionals to create a budget for the coming year and is typically based on monthly or quarterly figures.
4. Forecasting Model
The forecast model predicts costs within a company’s budget and you can use it for financial planning and analysis. It can assist your startup in estimating future expenses and developing a forecast that compares to the budget model.
5. Initial Public Offering Model
This financial model shows how much investors will pay once your company goes public. It entails conducting comparable company analysis for investors to determine the value of your company.
Hopefully this article has been useful for you for learning why financial modeling is important for startups and small businesses.