Why Financial Modelling is important for Start-Ups
Sankara Ramnath
For most early stage entrepreneurs, a financial model a standard spread sheet template that helps them prepare the financials slide of their Investment Pitch Deck. Start-ups find it difficult to simplify a complex business into a template spread sheet and end up with inconsistent numbers across the Deck and other documents. They fear that if don’t show a rosy picture, they may not get funds for business and hence the financials end up in the investment pitch deck, with cooked up figures and “hockey stick” projection, to show that the business can be a great success. The pity is that, more often than not, for the same reason an entrepreneurial idea gets rejected, because the financial model is not in sync with the business model. Many feel that the financial model is a work of fiction.
Result: Nobody believes the financial model.
So, do we throw out the financial model?
On the contrary. Throw out the standard template spread sheet if you must.
What is a Financial Model?
A Financial Model is the story of your business in financial currency. It is a mathematical representation of your business model that can be used to understand your business. It has a set of inputs and outputs. Inputs are the assumptions that go into the financial model and the outputs show the projected performance of the company, based on the assumptions.
The input assumptions are based on metrics that drive your business and consequently the model. Since every business is different, the assumptions and the metrics could be different.
Some common inputs.
- Burn Rate and fixed cost per month
- Per unit or per transaction cost
- The marketing funnel including the market potential, the customer acquisition cost, sign ups,
- User economics – churns, average order size,
- Monthly Recurring Revenue
- Business milestones
The outputs are the outcome as a result of the play of input metrics and their related assumptions. They are the projected performance of the company in financial terms or the currency of the land and represented by Income Statement or Profit & Loss Account, Balance Sheet and Cash flow statement.
Since the input assumptions can be different, one financial model can produce multiple set of projections. The input metrics and assumptions act as levers to produce different possible business results. The financial model, thus, shows how the company will perform going forward, under various scenarios.
Why do Start-ups need Financial Modelling?
1. Funding: Early stage entrepreneurs generally start preparing the financial model when they need to borrow funds from investors for their seed money. A good FM lets your potential investors know why you are asking for funds, when do you need it and what’s in it for them.
On the face of it, a financial model might seem as a tool purely intended for obtaining funds from investors However that’s not the only purpose. On the contrary, investors realise that forecasting for a new business is difficult and that your actual results can be different from your projections. At the seed stage especially, they bet on your business idea and on YOU.
2. Core information system: The investors and other stakeholders expect that you understand how your business operates and you will be able to kickstart it. A good financial model will help you do that. It’s an opportunity to show with numbers the very potential of your business and your capability to proactively manage growth. It is a reflection that you clearly understand your business and the levers that drive it. A good well implemented financial model can be the core information system to drive your business.
3. Understand and Manage Cash Flows: The biggest purpose of the financial model is to help the entrepreneur understand his cash. For most start-ups cash outflow precedes cash inflow A good FM helps you match you cashflows and understand when and how much tomorrow. You should be aware of your burn rate and know how long your money is going to last. It will help you understand the real economics of the business. This can be frightening sometimes, but it can tell you how deep is the well before you plunge into it. Once you are in, it is an indispensable cash management tool. Tracing the flow of cash within the company will help you to identify where money is locked up and improve efficiencies.
4. Performance Management System: A good FM is built bottoms up and therefore it forces you to think through all the variables that affect the operations and give insight into your business model. It helps you dig deeper into operational metrics.
It can be used to identify measurable key result areas (KRA’s) and Key Performance Indicators(KPI), which can be used as the basis for a Performance Management System. It helps you understand how sensitive your business is to the assumption levers and accordingly do a risk assessment to take proactive steps.
5. Create Benchmarks: A financial Model is not a one-time exercise. As you grow in business, the financial model will track history as it is written with the projections made earlier. It will give a financial trail – where you were and where are you now. It will help you create benchmarks and baselines for the future.
Start-ups need a rolling forecast that serves as a decision-making tool for a dynamic business in a VUCA (volatile, uncertain, complex and ambiguous) environment. The financial model should be able to do that. When any of the underlying assumptions of the input metrics change, the model must be able to change the forecasts.
6. Decision Making Tool: A financial model can help to understand how certain decisions might affect the future health of their company. It can thus be used to make smart decisions by playing with the variables to leverage for better performance.
The financial model helps in various decisions
- Arriving at the Break-even point which is how many units you have to sell or customers you have to get, to pay for your fixed costs
- Make or buy
- Product mix
- Pricing Strategies
- Understanding your cost structure
- Find out how effective are your marketing strategies.
7. Big Picture: Your financial model is much more than a mere accounting exercise. It is forecasting as well. A good Financial model provides the big picture. You take the various components- income and costs statements, cash flow summaries and the Balance sheet and piece them together to get a consolidated and comprehensive financial picture.
I have been building financial models with a lot of early stage entrepreneurs and seen them reap enormous benefit when it is built bottoms up, as it complements the business model and gives valuable information to improve profitability.
In my next instalments of Financial Modelling, I will cover “HOW to build a good financial model for Start-ups”
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