Financial Modelling and Forecasting
As an entrepreneur begins their start-up journey, there are many areas that that need to be researched, tested, and actioned, e.g., product development, market validation, customer discovery and raising funding. One of the most important items (that is sometimes left to last) is developing a financial model. A financial model is important to any business and should reflect the business model and the growth trajectory of the company.
Importance of Financial Modelling
There are a few key reasons why it is an important exercise for startup founders to develop a financial model:
1. Assist in the storytelling process and demonstrate the commercial viability of the company
A financial model build a narrative around your business performance and help start-up founders understand how things are going and where they’re headed. It can enable start-up founders project the full potential of their company.
2. Building a Hiring plan
It will help you plan your resourcing need, taking into consideration the stage of the company, cash available, and see how adding headcount can impact the company’s financial performance.
Angel investor, VC or any financial institution will typically ask for a financial plan when you engage with them to raise funding.
4. To inform yourself and prepare for potential future outcomes
With a financial model, you can examine and test a range of ‘What If’ scenarios and are able see the impact of predictable changes (i.e. increase in cost, decrease in selling price, increase or decrease in demand, etc.) to your business. You can check the impact to bottom line and cash flow requirements and navigate different financial strategies for the company.
A good financial model includes a forecast of three financial statements: the Profit & Loss statement, the Balance sheet and the Cash flow statement. These should be supported by a robust business plan typically covering at least the next 24 months of the startup journey.
The crucial part of preparing the financial model is identifying your key inputs and the assumptions around it. A finance professional typically use historical numbers to develop key assumptions. However, for start-ups where little or no historical financial information is available, you must be able to show the proof or clarification behind your assumptions. It would be beneficial to document how you have come up with your assumptions and to create a data room/cloud storage to store for the supporting documents substantiating these assumptions (i.e. market research, contracts with suppliers, pricing validation etc.), so you have the support for your financial model and are well prepared in case an investor might request a due diligence process.
The key inputs to a startup’s financial model are the following:
1. Revenue (revenue projections based on your business model and pricing strategy)
2. Cost of goods and services (what are the costs to acquire new customers or build a new product)
3. Headcount and hiring plan (the number and costs of employees you need to build a fast-growing company and the timing of hiring)
4. Operating expenses (how and where your company is spending – main expenses for start-ups are R&D, salaries, marketing & business development)
5. Payment terms (both for customers and suppliers)
It is very important to understand the impact of changes to the above key inputs. Testing these assumptions allow you to decide on the best financial strategy for the business and you are able to identify how much money you need at each stage of the company's development.
The two main approaches towards financial modelling are the top-down method and the bottom-up forecasting approach. Many will recommend forecasting from the top-down, for example looking at the overall market size and taking a % of the share to be your sales in year 1 and increasing by X% year on year. Here at South East BIC, we always work with our clients to build a bottom-up forecasting approach for the next 24 months. With the bottom-up approach, you estimate revenues, costs, production capacity, marketing spend, expenses, etc. based on internal company specific data, and as such, provides a more realistic target when forecasting.
If you are an innovative startup with plans to scale and internationalise and need guidance on your financial modelling and forecasting, you can reach out to Ayzel at firstname.lastname@example.org