A financial model is an excel spreadsheet that projects and forecasts a business’s performance into the future. It takes into account past performances, expenses, and revenue assumptions.
Having a financial model helps business stakeholders make well-informed decisions.
Bankers, credit analysts, accountants, valuation advisers, and research analysts use financial models to review the financial viability of a business.
Top Benefits of Using Financial Model for Business
Here are the reasons why businesses need financial modeling:
- First, financial models present quantifiable data, which is immensely useful in fundraising.
- It can attract investors who want to evaluate a company’s financial model before investing.
- It provides insight into whether an organization’s ideas are sustainable or not.
- It also helps in understanding the cash flow needs and revenue of a business.
8 Most Popular Financial Models Types
The most basic type of financial modeling. It links the three main financial statements – the balance sheet, income statement, and cash flow statement. This three-statement model acts as a base for other financial models.
Read more: Income Statement
It falls under the reporting model classification and can be used for planning a business’s annual budget and economic analysis. This type of modeling relies heavily on the income statement and uses it as a reference point.
The forecast model makes cost predictions within a company’s budget with the help of minute planning and economic analysis. As a result, it can help a business to determine its future expenses. For example, it can provide an idea about the costs associated with producing a product or service.
When two companies collaborate to form a consolidated entity, it is known as a merger. When one company acquires another, it is known as an acquisition.
A merger model provides valuable inputs about a startup’s pro forma accretion when there are talks of an acquisition or merger. This type of financial modeling helps people understand the overall capacity of a company merging with another business.
Discounted Cash Flow Model
A discounted cash flow (DCF) model helps to determine a startup’s current net value by building upon the basic three-statement model. It adjusts future cash flow to the time value of money to arrive at a company’s present value. DCF financial modeling allows the partners and investors to evaluate a business’s total equity.
Sum of the Parts Model
SOTP (Sum of the Parts) model helps to determine the net worth of individual units of a company. Business conglomerates commonly use it with various business units in different industries.
Initial Public Offering Model
A privately held company becomes public when its stocks are offered on the stock exchange in the form of IPO (Initial Public Offering). A company and investors can use this method to determine its value before going public. This financial model provides an overview of how much investors will pay once it becomes public.
Leveraged Buyout Model
When one company acquires another company using significant debt, it is known as a leveraged buyout. This model is used to assess the transactions of a leveraged buyout. It utilises cash flow statements, revenue and liability to understand better the connection between a company’s debt and cash flow.
How to Create a Sound Financial Model for Business?
Listed below are the necessary steps required to create a financial model:
Step 1: Define the goal of the Financial Model
In the first step, one must determine how complicated their model would be. It needs to be less complicated if one aims to do back-of-the-envelope estimates or market sizing.
If the financial model aims to raise capital, it needs to be detailed enough to show that the business owner has a clear idea about the market. A detailed analysis is a prerequisite for formulating an accurate financial model.
Step 2: Understand the KPIs of the startup
New businesses need to use industry-standard KPIs (Key Performance Indicators) as a reference point. These are numerical factors that are easy to track. Therefore, businesses must regularly track their performance against these KPIs.
Step 3: Use a Financial Model template
Creating a financial model can be time-consuming. To make financial modeling easier, businesses can choose from the many free templates available on the internet.
Step 4: Start with revenue forecasting
Here startups need to analyse what will drive revenue for their businesses. Business owners need to analyse the number of users, marketing activities and cost of products. Product development milestones provide a clearer picture for businesses dealing with hardware or biotech.
Step 5: Analyse headcount needs
An important step to get the model right is to properly analyse the number of people required to meet business goals. Recruiting costs are another aspect that needs to be considered.
Setting up a new venture is always a challenge. But RazorpayX is here to make the job of business owners easier. Our platform enables a startup to manage and control its finances from a single intuitive dashboard easily. We will explore that in a while. But first, let us look at the different elements of financial modeling.
Crucial Elements of a Financial Model
Detailed below are crucial elements of financial modeling for startups:
- Human Resource: The costs associated with new recruitment and salaries of existing employees come under the purview of ‘human resource’. This is why figuring out the workforce requirements of a startup is essential for making financial models.
- Revenue Assumptions: This is the money that a startup hopes to generate. Reasonable and realistic assumptions are required to drive accurate projections.
- Balance Sheet: It presents details of the assets and liabilities of a startup. In addition, it presents a picture of a company’s financial position at the end of the reporting period.
- Income Statement: It is an integral element of the financial modeling process. For accuracy, one must first determine the EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortisation).
- Cash Flow Statement: It helps to understand a company’s cash and bank balance at the end of a particular year. It provides a clear picture of the cash coming in and going out.
- Capital Expenditure: It is the expenses necessary for purchasing physical assets. Examples of expenses of a startup include software, office spaces and machinery.
- Sensitivity Analysis: This element helps analysts understand how the values may change if a company’s operating conditions or assumptions change.
Making a Financial Model
Here are some vital points that should be kept in mind while creating a sound model for startups:
- Determine the main problem first. Why does your business need this financial model, and what is the goal you wish to achieve with it?
- Limit the variables. Make sure that the variables and metrics that your financial model measures is minimal.
- Structure is important! The excel sheet used to make your financial model should be well structured. Use different colours for each formula and each metric.
- Use simple formulas. The formulas for calculations should be as simple as possible. Also, providing the break-up of complex formulas is necessary for clarity.
- Recheck the formulas. This helps to avoid inaccuracies and errors. If possible, ask someone else to check and review the financial model.
Today, financial modeling is an integral part of any new business, and not without reason. It is a crucial element in making financial projections and forecasting revenue.
Startups generally do not have large teams to deal with finances. So, they can consider taking help from RazorpayX, which is a one-stop banking solutions provider.
Is Accounting Knowledge Required For Financial Modeling?
Creating & understanding a financial model is difficult and most founders find it easier to outsource this task to their CA partners.
RazorpayX was built precisely with the aim to help founders focus on scaling their businesses while we create simple, innovative & beautiful products that take care of all aspects of money movement.
Let us look at the key benefits of RazorpayX for startups:
- This neo-banking platform offers a supercharged current account that can schedule payments in single clicks, auto-read invoices and give detailed financial reports from a single intuitive dashboard.
- It comes with a host of benefits such as seamless integration of accounting software such as Tally, 3-click payroll processing, a corporate credit card with 3x higher limit than traditional corporate cards, bulk payouts among other services.
1. Which type of data do most financial models begin with?
Financial models begin with the entry of past financial statements in a company. Generally, analysts consider the historical data of the previous 3 – 5 years.
2. How long does it take to build a financial model?
It might take more than three weeks to complete a financial model. This is because the process requires precision and double-checking.
3. What are the most popular financial modelling tools?
Financial tools are skills, elements and information that help analysts build financial models. Analysts need to make these tools using their knowledge of Microsoft Excel, decision-making skill set and colour formatting knowledge.
4. Is financial forecasting different from financial modelling?
Though there are similarities between them, there are crucial differences as well. For example, while financial modelling forecasts revenue and makes projections, financial forecasting represents a business's cash flow for a particular time frame.
5. What are the prospects after doing a financial modelling course?
After completing a financial modelling course, students can work as investment bankers, equity research analysts, financial analysts, directors and managers.