Building financial models for startups: Your crystal ball

The 2020 pandemic proved that things could change dramatically for any business in a matter of months. Overnight, the world went into a shutdown with an end date of TBD.

Business owners were left unprepared, nervous, and unsure of how badly the fallout would hit once the doors opened again. No one was prepared for the longevity of the pandemic and its lasting effects on business – over 200,000 businesses shut down in the first year alone. 

More than ever, founders need to be able to predict how events can affect their company, especially given the unpredictability of the world we live in today. To prevent any financial surprises – like the pandemic – startups need to utilize financial models and other tools that give them insight into their future.

You can use financial modeling to analyze your current financial situation and project where you might be in the future, as long as you have accurate financial statements to generate different models.

In this article, we’ll go over financial models for startups, find out why financial modeling is important, review types of financial modeling, and more.

What is a financial model?

Financial modeling is a powerful tool that enables businesses to understand and predict their financial performance. It involves compiling an overview of business profits and expenses to estimate the company's valuation or assess how it stacks up against its competitors.

Unfortunately, maintaining accurate and current financial records can take a lot of time unless you hire a fractional CFO. These services offer expert assistance in developing and evaluating financial models and making beneficial decisions for your startup.

Startup founders need financial modeling to avoid making costly errors, such as investing in a big project without considering budgets. Proper financial modeling is dependent on the accuracy of financial statements. 

By maintaining accurate and up-to-date financial records, you'll have the data you need for solid financial modeling and, ultimately, bookkeeping and accounting efficiency. By taking the time to understand your finances and plan for the future, you can set your startups up for success in the face of challenges and setbacks.

Generally, financial models are made on spreadsheets by inputting all the data manually. However, many companies use specialized finance software to automate tasks and streamline processes.

Components of financial modeling

There are several key components essential to creating a financial model for startups. With them, your team can create an accurate financial model.

Income statement

The income statement displays a company's total revenue for a given period. This statement lets you see everything related to your revenue, costs, and profits, including salary, rent, and marketing and sales expenses. By examining your income statement, you can evaluate your business's profitability and spot potential cost-cutting opportunities.

Balance sheet

A balance sheet provides a snapshot of your company's financial situation at a certain time and compares your business's assets, debts, and equity. You can understand your company's financial health and capacity to pay your debts through your balance sheet.

Cash flow statement

A cash flow statement shows how much cash your company generates and its allocations, including data on both cash inflows and outflows, such as sales or debt payments. With a cash flow statement, businesses can understand their liquidity and financial flexibility.

Debt schedule

A debt schedule is a detailed breakdown of a company's debt. Debt schedules include conditions on any loans, interest rates, and repayment plans. You can assess your company's total debt and capacity to handle it by looking at your debt schedule.

Why do you need to build a financial model?

Without a model, you have no financial insights into the future of your startup. A lack of financial clarity often leads to risky, uninformed decisions and an inability to attract investors to your project. Below are some of the most important things financial modeling allows you to do for your startup.

Secure investments

Investors do not necessarily require financial models when considering whether or not to support your business, but you can use a robust financial model to show investors that you have a sound plan in place for handling different scenarios that might arise during the early stages of your startup.

Once investors are backing you, financial models help hold investors' trust and are an excellent way to communicate and work through financial challenges together. 

Optimize budgeting

In addition to improving investor relations, financial models are crucial for budgeting and planning. Different models can help you forecast your cash flow more precisely and decide how to use your resources based on the situation. Having these plans in place is crucial during the early years of your startup while you are operating with limited resources. 

For example, you can use your projections to get ahead of the curve and stop allocating your resources in certain areas to avoid layoffs.

On the other hand, if you're expecting a good season, you can invest in innovative projects that could positively impact your organization in the long term.

Prepare for future challenges

Another key reason why you need financial modeling is to identify and prepare for any financial challenges that may lie ahead. The Sensitivity Analysis model answers all the "what if" questions you may have.

For example, what if there is a recession? Sensitivity Analysis (which we’ll discuss below) lets you know what would happen based on these assumptions. Then, you can prepare a plan in case those scenarios happen.

While you might not be able to predict a worldwide event, like the 2020 pandemic, you can assume a range of scenarios that can help you set preventative company internal controls. 

Determine viable business decisions

Financial modeling can help you determine how various company decisions could affect your financial performance.

For example, you may want to know how raising prices could affect customer behavior. Using historical data and assumptions, you can determine how a price increase could result in service cancellations and other factors. Ultimately, financial modeling will tell you how much you can increase prices and remain profitable.

Common financial models for startups

While businesses can use many different types of financial models, startups should use three common models: the 3-Statement Financial Model, Discounted Cash Flow (DCF) Analysis, and Sensitivity Analysis.

3-statement financial model

This type of financial forecasting model for startups allows you to project the future performance of your business. The three financial statements that make up the model are the income statement, cash flow statement, and balance sheet.

The 3-statement financial model works by dynamically linking the three documents so that a change in one affects the other two. This model uses historical data and assumptions to drive a reliable forecast. To use this model successfully, you must ensure that your financial statements are accurate.

For example, suppose your startup wants to understand the impact on cash flow, debt, and equity from business operations decisions like lowering prices, getting a loan, or investing in a business tool. In that case, a 3-statement income can show it to you.

This happens because when you forecast a change to one of the documents, for example, the cash flow statement, it will automatically affect the income statement and balance sheet

Discounted cash flow analysis (DCF)

DCF Analysis is a financial model that values a company by forecasting its free cash flows using your cash flow statement. 

DFC analysis predicts how much money the company will generate in the future. The financial analysis considers revenue growth, expenses, and capital expenditures. Using a discount rate, you use these forecasted cash flows to determine their present value.

For example, a common use case for DFC analysis is when a startup wants to evaluate investment opportunities and assess the potential returns of a new product launch. This calculation can show you exactly how much money you need to consider the investment worthwhile.

Sensitivity or "What-If" analysis

Sensitivity, or "What-If," analysis shows the effects of changes in assumptions such as selling price, supply chain costs, fixed costs, and forecasted sales on your company's financial performance. It's a useful tool for financial advisors to analyze the impact of different scenarios on a company's revenue, profits, and other financial aspects.

To perform a sensitivity analysis, CFOs typically develop a financial model that includes various assumptions relevant to the company's financial performance. They may then change one or more of these assumptions and see how it affects the company's financial results.

For example, they may increase the selling price of a product and see how it affects the company's revenue and profits. Alternatively, they may decrease the supply chain costs and see how it affects the company's bottom line.

Can't startups use other modeling methods?

As a founder, you might be thinking about other modeling methods that you've seen work for other companies. While those methods are useful, they might not be relevant for an early-stage startup.

Here at Zeni, we used multiple modeling tools and struggled. We finally realized during our first startup venture that applying all the tools in our arsenal toward the most startup-relevant financial models was the best way to approach business decisions and development.

Scaling startups can use more complex financial models, but in the beginning, you need to focus on growth metrics. In the beginning, focusing on complex methods that forecast irrelevant metrics will counter lose your time and effort. Focusing on the metrics that truly matter for your business first will help you build effective financial projections that drive your growth.

Regardless of your startup's size, financial models are essential for crafting your future. Without them, you’re scaling without an accurate business plan.

Is financial modeling for startups different?

Financial modeling for startups is different from financial modeling for traditional businesses in a few key ways.

One of the main differences is that startups grow rapidly. Quick expansion means that financial models for startups have more growth factors that you must consider. These growth factors include hiring, increasing revenue, marketing spending, and other essential costs related to scaling a startup.

In addition, the differences in a startup's key performance indicators (KPIs) influence how you build financial models. Alternative building happens because startup KPIs are often more customer-focused.

For example, a startup may be more concerned with acquiring new customers or retaining existing ones rather than focusing on traditional financial KPI reporting like ROI.

However, as a startup scales, it may use more traditional financial models to guide its business decisions.

SaaS financial modeling

Software as Service (SaaS) businesses differ from other startups because they operate on a subscription-based model. In a SaaS startup, customers pay a recurring fee to regularly access the company's software. Building financial models for SaaS has a few specific considerations due to the structure.

1. The SaaS business model focuses on recurring subscribers' revenue rather than one-time product purchases. The subscription cycle is why a SaaS business financial model often revolves around user and feature metrics. Subscription-based KPIs show how much revenue each user brings in, how long users typically remain loyal to the company, and how much it costs to acquire a user.

2. SaaS businesses must wait for an entire subscription cycle to count revenue from a sale. For example, if a customer subscribes to Spotify for $10 per month, Spotify will not count that revenue until the full bill cycle has gone through. In other words, SaaS revenue grows based on subscriptions and remains relatively stagnant. SaaS companies must rely on past months' subscription data to predict future revenue if the subscription amount stays the same.

3. SaaS startups often incur high costs to get started due to the expenses associated with software development and research. As a result, SaaS companies focus heavily on customer retention and growth to spike their revenue. SaaS companies can project revenue based on their new customer growth rate analytics by analyzing these metrics. This information can help SaaS companies make informed decisions about optimizing their pricing strategies, improving customer retention, and driving growth.

What are financial projections vs financial modeling?

A financial projection also referred to as a financial forecast, is a thorough estimation of a company's anticipated earnings, expenses, and cash flows over a given time frame. Projections typically involve a combination of historical financial data and assumptions about future market conditions, business performance, and other factors. With this information, founders and business owners can make smarter business decisions related to budgeting, financial planning, and expansion.

In contrast, financial modeling takes the information and data from these forecasts and uses them to simulate different scenarios that might impact the business.

Can i build my own financial models?

There’s a high chance you monitored your own finances in the early stages of your startup. You may be doing so now. As DIY friendly as the world is today when it comes to money management, especially in startups running a mile a minute, doing your own finances has more cons than pros.

On top of needing financial education, you’re running a startup! Yes, you may be a great multitasker, but you shouldn’t put your startup’s finances at risk, especially when it comes to future projections and planning for multiple situations like another shutdown.

Unless you have heavy financial experience, it’s better to get advice from someone with startup finance experience. Fractional and full-time CFOs are experienced professionals who can build financial models, analyze trends, and give advice. However, if they don’t have experience in startups specifically, they may be unfamiliar with your needs.

Fractional CFOs are cost-effective but offer the same expertise as full-time CFOs — a definite pro for startups on a tight budget. 

The future isn’t linear. Unexpected situations can hit any moment – don’t put yourself in a position you can’t climb out of. Utilize these financial tools to better prepare for what comes next. 

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