Creating a financial forecast is one of the most important things a business can do – and a financial model represents the means to help achieve this. A financial model is a tool that helps analyze a company’s historical performance, relevant market data and information on comparable companies to project financial performance now and in the future.

Such models are ideal for profitability and valuation analyses and for helping startups better understand any operating drivers that can impact business performance to help further guide decision-making. However, to realize the benefits of a financial model, it’s important to know how to build one. 

What is a Financial Model and Why Are They Important for Startups?

Financial models are helpful tools that help business owners understand and analyze the impact that historical data and operating drivers can have on overall performance. While startups may not have much historical financial data to pull from in creating a model, they can use other metrics – such as financial inputs and outputs, revenue forecasting and more to help identify sales goals, break-even points or the level of sales needed to turn a profit. More established businesses are usually best served recovering at least the previous three years worth of financial data to create a robust financial model.

Financial models are tools that can also be used to secure investments, help with budgeting and help business owners better understand financial performance and adequately prepare for challenges in the future.

Good financial models don’t just set a course for the future, they also represent the past and present as well. For startups, however, they’re particularly useful serving as that financial roadmap that guides a business on its growth path. It can help project revenue, expenses and identify pain points to set realistic growth targets.

There are various types of financial models, with some of the most popular including:

• The 3-Statement Model
• The Discounted Cash Flow Analysis Model
• The Merger Model
• Comparable Company Analysis
• Capital Investment Model

Creating a financial model isn’t as easy as it may initially seem. You need to have a good grasp of basic accounting principles to know what figures to include and to get the most out of any model that’s created for your startup. The lack of financial knowledge can cause some startups to seek help creating a financial model with an external finance partner.

Benefits of Building a Startup Financial Model

There are many benefits to building a robust financial model for a startup. Some of these include:

• Making better business decisions: Startups have a lot of key decisions to make in the early days of their business that can have a major impact on the future. A good financial model can better help startups understand their current cash flow statement and estimate their future financial standing to help make more informed, data-driven decisions.
• Communication with stakeholders: Startups often rely on investments from stakeholders to grow. Financial models can help communicate various financial concepts and create a snapshot of your financial performance to help make your startup more attractive to invest in.
• Optimize budgeting: Every business should have a budget and balance sheet, and startups are no exception. Financial models can help startups better forecast cash flow and determine how income statement resources are best utilized.
• Investments and financial planning: Any business has key financial decisions that it will need to make over time that can have a big impact on revenue growth and future performance. Startups, however, tend to have more of these in the early days of the business, which can have a major impact on their future. Financial models can help startups determine where to allocate capital and how to plan for the future.

How to Build a Financial Model for Startups in 6 Steps

Curious how you can build an effective financial model? Here’s a look at how to do it in six steps:

Step 1: Gather Historical Data

The first step to creating a financial model is gathering historical financial data. Think of this data as the grounds for starting your financial model, as it can be used for more than just understanding past performance, but predicting future patterns, market movements and more. It’s best practice to gather at least three years worth of past financial data to base any financial models on.

Step 2: Calculate Ratios and Metrics

Next, you’ll want to accumulate key ratios and metrics based on the historical data that you gathered in the first step. These include sales growth rate, churn rate, expansion rate and more. By gathering this data, your model will be better able to predict any patterns or movements that you may have to anticipate in the future.

Step 3: Make Informed Assumptions

Now that you have your historical data, ratios and metrics, you can build out predictions to help anticipate the future of your company and any decisions you’ll have to make moving forward. In this step, you can get a better understanding of potential future growth margins and rates, turnover assets and potential changes in inventory in the future.

Step 4: Create a Forecast

Now that you have all the necessary data at your fingertips, you can forecast some of the basic accounting that can help you better understand your startup in the present day and where you want it to go in the future. In this step, you should be able to forecast future financial statements such as income statements, balance sheets, cash flow, and more. These statements are built out using any previous assumptions and historical data.

Step 5: Value the Company

Business valuation is a process to determine any company’s economic value. It includes factors such as assets, cash flow, earnings and more to come to a fair value. Business valuation is determined using the Discounted Cash Flow (DCF) model, which helps determine the value of an investment in the present day based on how it’s projected to perform in the future.

Step 6: Review and Refine

Financial models aren’t just something that you create and let sit – they can and should be reviewed and refined to see how different scenarios can play out based on some of the data that you need. Remember, financial models rely on assumptions to calculate projected value. It’s important to test the various formulas and your assumptions to identify all probable and possible values.

How to Know if Your Financial Model Is a Good One

There’s a fine line between a good financial model and a poor one – and the best ones tend to follow certain best practices. These best practices include:

• Having an easy-to-understand layout and being properly structured
• Making any assumptions clear
• Highlighting the important data
• Incorporating visuals to enhance comprehension
• Ensuring accuracy

To create a good financial model, be sure to follow the six steps to a “t” and have an idea in mind on how you expect the structure to appear. This can help streamline the model’s creation and avoid the necessity of making any adjustments. Using a good financial modeling template can also help with this.

Common Challenges in Financial Modeling for Startups and How to Overcome Them

Financial models are complex and require a vast amount of data to create one that’s both accurate and impactful. That said, it shouldn’t surprise you to learn that there are various challenges that you’re likely to face – and have to overcome – when it comes to creating one that can go to bat for your startup.

When you build financial models, some of the common challenges include:

• Poor data
• Data availability
• Unrealistic assumptions
• Lack of understanding of accounting principles
• Properly managing uncertainty
• Failure to adapt to changing business environments

If you’re uncertain as to whether or not you’re able to create an effective financial model for your startup, one of the best things you can do is work with a qualified accountant who specializes in such services. While you could attempt to follow a financial model template on your own, a good accounting partner can take much of the guesswork out of creating a financial model and ensure that the model that’s created meets the needs of your startup in the present day and into the future.

Master Your Financial Modeling Skills with Graphite Financial

Financial models are important for more than just providing a snapshot of your startup’s performance in the present day, but for making decisions related to how you want it to perform in the future. To create a robust financial model, it’s important to have the right skills and know some of the necessary basic accounting principles. Many startups don’t have the resources to put toward this, underscoring the need to work with someone who does. That’s where Graphite Financial can help.

As qualified, experienced accounting experts, Graphite will work with you to create a financial model that can help go to work for your startup. For more information, contact us today. We offer free trials and consultations, and our services are available at various price points to meet any budget. Learn more by contacting us today.

FAQs

What are the key steps involved in building a financial model?

There are six key steps involved when effectively learning how to build a financial model. They are: gathering historical data, calculating ratios and metrics, making informed assumptions, creating a forecast, valuing the company, and reviewing and refining the forecast over time.

How can financial modeling be utilized to enhance business decision-making processes?

A good financial model is used to assess a business’s past, present and future. It can help leaders make investment decisions, assist with budgeting, help with financial planning and more. A good financial model can also help communicate more complex financial concepts to stakeholders or help entice potential investors.

What are the essential components of a well-designed financial model?

A good financial model is structured, clear and accurate. It needs to avoid some of the common pain points associated with financial modeling (i.e., inaccurate assumptions, poor data, failure to manage uncertainty, etc.). Following the six steps to build an effective financial model can help.

How can financial modeling assist in forecasting future financial outcomes for a business?

Financial models rely heavily on historical data, which can be a huge tool when trying to determine future financial outcomes. Historical data can be used for more than just understanding past performance, but predicting future patterns, market movements and more. It’s best practice to gather at least three years worth of past financial data to base any financial models on.

What are the main challenges faced when building financial models, and how can they be overcome?

Some of the common challenges in financial modeling include poor data, lack of data availability, unrealistic assumptions, lack of understanding of accounting principles, properly managing uncertainty and failure to adapt to changing business environments, among others. The best way to avoid these challenges is to be realistic about any assumptions that you make. Keep in mind that creating a financial model also requires some basic accounting skills and knowledge, which can be a challenge for startups. If you’re uncertain about how to create a financial model, consider working with an external accounting partner for help.

How do I ensure the accuracy and reliability of my financial model?

In addition to following the six steps to building a financial model, some other tips include the following: having an easy-to-understand layout and being properly structured, making any assumptions clear, highlighting the important data and incorporating visuals to enhance comprehension. If you’re uncertain about your ability to create an effective financial model, one idea is to work with a third party or external accountant to ensure it’s done correctly.