What is a financial model?

This tutorial will teach you how to build and structure a financial plan. A well-structured, accurate, and in-depth economic model gives you the tools to forecast and project your company’s future performance.

What is Financial Modeling?

A financial model is the mathematical representation of a company’s workings. Financial modeling is a way to create a model that can be used to predict the financial performance of a business, give direction, and provide context for uncertainty. Imagine that the model is a machine. We put in fuel, like salaries and costs of customer acquisition, and it produces outputs such as projections for the company’s future performance. It can be not easy to decide which assumptions to use and how to project accurately. However, it is well worth the effort because sophisticated models serve as powerful tools for decision-making and forecasting. What other reasons are there for modeling? How do we build financial models?

Why is financial modeling important?

It is unlikely that the outputs of a financial model will match reality perfectly. Economic models are built on a limited set of assumptions based on a wide range of inputs. Why should business owners bother to develop a financial model when there is so much uncertainty? Why do investors care about it so much?

Investing in the development of finance skills will increase the chances for success. Founders should invest significant resources in building their model. This can be viewed as a manifestation of financial skills. These two reasons are:

The financial model provides direction for the company. It can also reveal the key business drivers and, in cases of significant deviations, provide insight into where the firm should concentrate to manage or hedge risk.

It shows investors that the founders understand their business and are able to make reasonable assumptions. This model is also a tool that helps determine the value of the company.

Management should avoid simply trying to find a template. The template will give you an idea of how to build a model and indicate missing elements. But it won’t do much more. A financial model template is a representation of a business that has different characteristics and needs. A proper economic model must be created from scratch. Custom models demonstrate that the founders are familiar with their business, and they should have a keen business sense. A well-constructed, sophisticated financial model increases investor confidence and can increase the likelihood of funding. It can be an excellent investment to work with a leading financial modeling expert who can help you create a robust and comprehensive model.

Top Down

We start by defining the goals that need to be achieved to reach our target. If we are a mobile nutrition company, for example, we begin by saying the market is valued at $27 billion in 2017 and that we will be able to capture 7% by year 2. We defined revenue in this way and then calculated costs to achieve this goal.

Bottom Up

In a bottom-up method, on the other hand, we begin with assumptions (e.g., the number of salespeople needed and their cost, the attractiveness of the business, and the traffic) to build a financial model. We can then create scenarios to see how assumptions need to be changed (e.g., how many salespeople are required) to reach our goals.

What is the best approach?

Top-down approaches, especially in the case of a startup, are often opaque and based on subjective, overly optimistic predictions or desires. Bottom-up approaches can be more valuable in gaining a deeper understanding of a model. The top-down method can be used to ignore the current situation but provide valuable inputs about milestones that need to be reached. For financial modeling, a bottom-up perspective can offer a realistic, structured view that can be enhanced from a strategy perspective by some top-down analyses.

How to build a financial model and what we should be aware of

Once you’ve decided on the type of economic model you want to create, you must understand all of the components that make up a dynamic economic model.

The two main components of a financial model are the three statements, namely the income statement, the balance sheet, and the cash flow statement. Additional parts, depending on the needs of each company, can be added. These include capital sources and allocation, valuation, and sensitivity analyses (outputs for different scenarios). We’ll look at some of the key characteristics of each, as well as examples of the components of financial models.

This tab should be the very first one in a spreadsheet. It contains variables that are used on the other charges. The rest of the costs will not require any manual input, and all numbers are sourced from the assumptions tab.

These assumptions are specific to each business, and they include topics such as revenue (e.g., growth rate), cost (e.g., salaries), and capital (e.g., interest rate). These assumptions must be reasonable and based on solid research. A startup, for example, has higher marketing needs and should not use the average expenditure of large, mature companies. To keep the list neat, it is better to base assumptions on the actual needs of your model rather than an endless, difficult-to-use index. To reach solid conclusions, it is recommended that you use evidence, define benchmarks, and create ranges for certain assumptions when building financial models.

We can also add supporting schedules as tabs or as part of the assumptions. If the business is in debt, an amortization chart should show the repayments and interest payments as well as the progress.

The Income Statement

The income statement displays the revenue and costs of an organization and shows if there are profits or losses. The income statement is split into two sections: operating and not operating. For example, if a software company sold a property, its revenues would be non-operating because real estate is not their core business.

Why is it so useful? Investors (and entrepreneurs) can use the income statement to check on the growth forecast, the margins, the relative weight of the costs, and the revenue.

Once the assumptions are in place, you can complete the income statement: revenue, direct costs, and gross profit; operating expenses and EBITDA; non-operating expenses and earnings before tax. Depending on the level of detail that we require, we can also create sub-categories. For example, suppose we have a new startup that has more than one source of revenue. In that case, we can include each revenue source under the revenue line (e.g., revenue from advertising, revenue through subscription). It is not enough to read the numbers. You must also understand what they mean. EBITDA is one of the most commonly used metrics. It’s a good indication of operating capability, but it has its pitfalls. Below is an example of a financial statement. For the first year, it is best to have a breakdown by month:

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