A startup financial model is a document that describes a company’s financial strategy in perspective.
It can be used to attract investors as it shows the company’s profit and growth potential in the future. But without proper analysis, the model is meaningless.
Here, created a large guide where explained almost everything about this – how to develop a financial model and work with it so that it helps in managing finances and attracting investments.
We have three very easy questions for you:
- Do you want to build a (financially) sustainable business?
- Are you looking for funding?
- Do you want to avoid going bankrupt?
Probably you have answered yes at least once. If you have founded your own company, probably yes applies to all three questions.
To cover all three having (some form of) a financial model is crucial. Whatever the reason is for you ending up at looking at this article, apparently also for you financial modeling is an important topic, otherwise you wouldn’t be here, right? 😉
Well, you have come to the right place! Having supported around a thousand startups and scale-ups with their financial models over the past couple of years with the EY Finance Navigator team, we have written everything you need to know and all the best practices available around financial modeling for starting businesses: the ultimate guide to financial modeling for startups!
NOTE: in this article we are not sharing any financial modeling templates. Why? There are tons and tons of them already available online: simply look for ‘financial model template’ on the web and you are done.
This article is written with the purpose of doing something a template cannot do for you: helping you understand the different elements and technicalities of a startup’s financial model, learn how to fill it in and do checks on your data so you are able of making sense out of the outcomes yourself. And if you need additional support, feel free to reach out using the contact form.
Goals and objectives of the financial model of a startup
Before diving into the process of building a financial model, let’s consider its goals and objectives – after all, without understanding why you need it, it will not be possible to build a high-quality model.
In fact, the financial model has many goals and objectives, but two main points will be enough for a novice startup.
1. Assessment of startup sustainability, risks and opportunities
Before presenting your project to investors, you first need to make sure that your startup will be sustainable and will not fall apart at the first jumps in the economy.
Goal: Assess the sustainability and long-term profitability of a startup.
Tasks:
- Analyze the market and identify potential competitors.
- Estimate the size of the target audience and the demand for the product.
- Calculate the expected income and profit depending on the volume of sales.
- Estimate the costs of production, marketing, administrative expenses and other costs necessary to maintain the business.
- Compare expected profits with costs and estimate how long it will take to maintain the business to achieve profitability.
2. Preparation for attraction of investments
Perhaps, the main point for the sake of which the construction of a financial model is started. Without this investment model, you will not see, you need to convince investors that it is your project that will enrich them.
Objective: To prepare for attracting investments and provide investors with reliable data on the financial condition of a startup.
Tasks:
- Calculate the expected value of a startup based on an assessment of its financial strength, market position, growth potential, and other factors.
- Develop a plan for the use of investments and evaluate how they will contribute to the development of the business.
- Prepare a detailed financial report that includes projected income and expenses, planned investments, expected profitability and other financial indicators.
- Assess the risks and opportunities associated with attracting investments and provide investors with reliable information about the financial condition of a startup.
Why do you need a startup financial model figured out – it’s time to dive deeper into the topic.
Startup financial models: concepts and types
The financial model may include various types of financial reports, forecasting of income and expenses, assessment of potential profitability and risks, and other financial indicators. It can serve as a basis for making investment decisions.
There are several types of startup financial models , including:
- Income and Expenditure (P&L) Forecasting Model
It is a detailed financial statement that shows the expected income and expenses of a startup for a certain period of time (usually a year).
It includes calculations for sales, cost of sales, operating expenses, taxes and other financial indicators.
- Cash flow forecasting model
A tool that allows you to predict the receipt and expenditure of funds in the future. It takes into account all income and expenses, including investments, loan payments and other transactions.
- balance model
A financial report that shows the financial condition of a startup at a specific point in time. It includes the assets, liabilities and capital of the company.
This model can be used to assess the financial sustainability of a startup and plan future investments.
And, yes, you will need to calculate each indicated indicator:
- Profit and Loss Statement – financial plan for income and expenses
- Cash Flow Statement – cash flow statement
- Balance Sheet – balance sheet
Financial income and expense plan (P&L)
An income and expense financial plan is the main element of a startup’s financial model, where expected income and expenses for the year help determine profit or loss.
Revenues include sales, rentals and commissions. Expenses – salary, rent, purchase of materials and marketing. Each line should be summarized taking into account the frequency and mandatory payments.
This plan helps you optimize your business strategy, increasing revenue and reducing costs.
Statement of cash flows (CF)
A financial report on the movement of funds in an enterprise over a specified period of time.
It includes cash flows from operating, investing and financing activities.
- operating activities – sales revenues and expenses for salaries and materials,
- investment activity – long-term assets,
- financial activities – changes in equity, lending and dividends.
The report helps you plan and forecast future cash flows, optimize your business strategy and plan your budget.
Balance sheet (BS)
A balance sheet is an important financial document that reflects the financial position of a company on a specific date.
It includes information about assets, liabilities and equity.
- assets are what the company owns,
- liabilities are her debts,
- capital – the equity capital of the company.
The report must be drawn up in accordance with accounting principles. It helps in making financial decisions, in particular, when investors decide to invest in your project.
How to build a financial model for a startup? Algorithm for developing a financial model
The correct financial model for a startup will help to carry out strategic planning and identify potential financial risks and opportunities.
Here is a step-by-step algorithm for developing a financial model for a startup.
Step 1: Define Key Variables
Identify all the key variables that can affect the financial success of your startup.
This may include:
- number of sales
- product cost,
- marketing and advertising costs,
- taxes,
- wages, depreciation, investments.
Step 2: Define Yearly and Monthly Forecasts
Predict key metrics for the year and month for each key variable.
For example:
- how much product do you plan to sell in the first year,
- what price are you going to set?
- what will be your marketing costs.
Step 3: Create an Income and Expense Table
Where all the income and expenses of your startup will be reflected. Make sure to include all the variables you defined in the first step.
Step 4: Determine the break-even point
This is the amount of product you need to sell to cover all costs. It will help determine how effective your business model is.
Step 5: Conduct a scenario analysis
It will allow you to determine how changing key variables can affect the financial results of your startup. This will help develop strategies to mitigate risks and seize opportunities.
Initial data for the development of the financial model
The input data used to develop a startup financial model can vary by industry and specific business.
However, in general, to build a financial model, you must have the following data:
- Sales volumes and sales prices.
- The cost of production or the cost of services provided.
- Required investment.
- Operating expenses.
- Taxes and other obligatory payments.
- Forecasted indicators of the market.
- Other industry and business specific factors.
The input data for developing a financial model should be as accurate and realistic as possible so that the model will give accurate forecasts and business estimates.
It is also necessary to regularly update the data in accordance with the changing market situation and internal changes in the business.
How to evaluate income?
Estimating earnings in a startup financial model is the process of predicting the expected level of earnings that a company can achieve in the future based on its current strategies and plans.
- Conduct market research and identify an understanding of how competitive a product or service that a startup offers can be. This can be achieved by analyzing competitors and industry trends.
- Determine the potential market share that the startup can capture. This can be done by defining the target audience and assessing its size – and also what positions competitors occupy in this market.
- Determine startup pricing policy . It must be competitive and at the same time provide a sufficient level of profit. Prices can be fixed or variable depending on various factors such as volume of purchases, seasonality.
- Determine the expected sales volume . It can be determined on the basis of market research and an assessment of the startup’s ability to attract the target audience and capture market share.
- Estimate what costs will be needed to achieve those sales. This may be the cost of production, marketing, personnel, rental of premises. Cost estimates should be as accurate as possible to give a realistic picture of the startup’s financial health.
Finally, based on all these factors, expected returns and profits can be determined. They can be calculated as the difference between expected revenues and costs.
Now to the costs.
How to plan expenses?
To plan the expenditure side, when building a financial model for a startup, it is necessary to take into account all possible costs that may arise in the course of its activities.
The classic way of calculating is to determine the goal, the necessary resources for its implementation and calculate the price of these resources.
Consideration should be given to the possibility of changes in costs depending on external factors:
- changing market conditions,
- changes in tax laws.
There are two main approaches to building financial models for startups to help you estimate income and expenses:
- Model from bottom to top (bottom-up);
- Model from top to bottom (top-down).
Model from bottom to top (bottom-up)
A method where you start with an end goal and break it down into smaller components.
This approach is usually used when you have data about specific transactions, such as product sales, payroll expenses.
This data is then put together to create a broader forecast of the company’s financial health.
In the context of a startup, this could mean that:
- You start with an estimate of monthly expenses (salary, office rent, marketing).
- Then you forecast monthly revenues based on projected sales and prices.
- You create an overall financial model that shows how all of these components work together.
Model from top to bottom (top-down)
A method that starts with broad indicators and gradually refines to specific numbers.
This approach is most often used when you don’t have data on specific operations, but have a general understanding of the size of the market and the potential demand for your product or service.
In the context of a startup, this could mean that:
- You start by estimating the size of the market you are going to be in;
- Predict your market share based on competitive analytics and trend analysis;
- Then you predict total revenue based on the price of the product and the number of sales.
- You create a detailed financial model based on these general indicators.
Both approaches are useful in building financial models for startups, and they are often combined to provide more reliable data.
Interrelation of financial model blocks
The idea of this paragraph is in one thought – everything is interconnected; one indicator affects another, another indicator affects the third, and the third generally affects the entire business.
The main blocks of the financial model of a startup are:
- Market: This block analyzes the startup’s target market, its size, competitors, and other factors that may affect sales.
- Finance: financial indicators are determined here – revenue, expenses, profits, taxes.
- Capital: this analyzes the sources of capital that a startup can use to finance its activities – investments, loans.
- Production: This block describes how a startup manages money in production.
The relationship between these blocks is important for the successful operation of a startup, and each indicator is interdependent – one can collapse the other with its unprofitability.
It also works vice versa: one indicator has grown and “pulled” others along with it.
Therefore, in order to create an effective financial model for a startup, it is necessary to take into account the relationship between the blocks and build them so that they support each other.
Summary
Financial modeling is an important topic especially when you founded your own company. We have written everything you need to know and all the best practices available around financial modeling for starting businesses.
