What is a Financial Model?
A Financial Model is a summary of a company’s revenue and expenses. Using historical data, a Model allows the business to track KPIs (Key Point Indicators) such as gross and net margin, as well as forecasting future performance, based on critical metrics such as customer cost of acquisition.
For startup founders and small business owners, the Financial Model is a fundamental tool for managing the business and making educated business decisions about the company’s future.
The Basics of Financial Modeling
Financial modeling is a representation in numbers of a company’s operations in the past, present, and the forecasted future. Such models are intended to be used as decision-making tools. Company executives might use them to estimate the costs and project the profits of a proposed new project.
Financial analysts use them to explain or anticipate the impact of events on a company’s stock, from internal factors, such as a change of strategy or business model to external factors such as a change in economic policy or regulation.
It is used to estimate the valuation of a business or to compare businesses to their peers in the industry. They also are used in strategic planning to test various scenarios, calculate the cost of new projects, decide on budgets, and allocate corporate resources.
Three reasons for having a Financial Model as a Startup
1. You need one to build an economically viable business. Why? Because by quantifying (and then validating) your business plan and business model, assumptions and vision you are able of finding out whether you can turn your ideas into a sustainably operating business.
Moreover, if you build different versions, you are better prepared for the future, especially if things do not go the way you planned. What if you launch half a year later? Answering such a question in your “worst case scenario” helps you anticipate how your cash flow, profitability and funding need are impacted.
2. You need one as part of the fundraising process. Financiers will typically ask you for a financial plan when you engage with them to raise funding. Certain investors will require more details than others, but building a model is wise even if you only need to provide them with high-level data.
Why? Because it helps you answer the tricky questions a financier might have when he or she dives into your business case. Moreover, how are you planning to raise funding if you did not properly calculate how much funding you actually need?
3. You need one to inform yourself and shareholders. How do you know how your company is doing if you don’t have any targets to achieve or steering information to compare against? How are you going to update your shareholders on how you are spending their money and whether you are performing as promised without any financial plan to benchmark against? You will need a forecast to do so.
You can get the Startup Financial Model template here.
Types of Financial Modeling
1. Three-Statement Model
A three-statement model links the income statement, balance sheet, and cash flow statement into one dynamically connected financial model.
2. Discounted Cash Flow (DCF) Model
it falls under the category of Valuation models and are typically, though not exclusively, used in equity research and other areas of the capital markets.
A DCF model is a specific type of financial model used to value a business. It is a forecast of a company’s unlevered free cash flow discounted back to today’s value, which is called the Net Present Value (NPV).
3. Merger Model (M&A)
The M&A model also falls under the Valuation category.
As the name implies, this type of financial modeling is towards a more advanced model applied to assess the pro forma accretion/dilution of a merger or acquisition.
It’s common to use a single tab model for each company, where the consolidation is represented as Company A + Company B = Merged Co.
4. Initial Public Offering (IPO) Model
Like the previous two type to financial models, the IPO model is also a Valuation model.
Financial professionals like investment bankers develop IPO financial models in Excel to value their business just before going public. These financial models equate company analysis with regards to an assumption about how much investors would be willing to pay for the company in contention.
5. Leveraged Buyout (LBO) Model
A leveraged buyout (LBO) is a transaction where a company is acquired using debt as the main source of consideration.
These transactions typically occur when a private equity (PE) firm borrows as much as they can from a variety of lenders (up to 70 or 80% of the purchase price) and funds the balance with their own equity.
When it comes to an LBO transaction, the required financial modeling can get complex. The added complexity comes from the following unique elements of an LBO:
- High degree of leverage
- Multiple tranches of debt financing
- Complex bank covenants
- Issuing of Preferred shares
- Management equity compensation
- Operational improvements targeted in the business
6. Sum of the Parts Model
Another type of financial model that belongs to the Valuation category of financial models, this model is developed by taking in account a number of DCF financial models and adding them together.
7. Consolidation Model
The Consolidation Model belongs to Reporting Model category of financial models.
It includes several business units added into one single model for financial modeling and further analysis.
Typically, each business unit is its own tab, with consolidation tab that simply sums up the other business units.
8. Budget Model
The Budget model is used to do financial modeling in financial planning & analysis (FP&A) to get the budget together for the next few years, typically in the range of one, three and five years.
Budget financial models are meant to be based on monthly or quarterly figures and rely strongly on the income statement.
9. Forecasting Model
Similar to the budget model, the forecasting model is also used in FP&A to come up with a forecast that compares to the budget model.
Since it is similar to the forecasting model, it also belongs to the Reporting model category of financial models.
10. Option Pricing Model
This model is part of the Pricing model category of financial models.
Binomial tree and Black-Sholes are the two main option pricing financial models and are based purely on mathematical financial modeling rather than specific standards and therefore are an upfront calculator built into Excel.
- Financial modeling is a representation in numbers of some or all aspects of a company’s operations.
- Financial models are used to estimate the valuation of a business or to compare businesses to their peers in the industry.
- Various models exist that may produce different results. A model is also only as good as the inputs and assumptions that go into it.
- Startups need good Pitch Deck to attract investors.
To create bulletproof financial models in seven easy steps, you can follow this article.
As a case study, you can see how Signal Private Messenger, a startup, was founded and funded. You might also be interested in reading an amazing story of an Indian startup, InMobi, to get the insight of financial managements.