The 2 most common reasons I hear for startups without a financial model are:
- Lack of knowledge - most entrepreneurs don't know how to create a model.
- Lack of time - most people think creating a financial model will take days.
The goal of this post is to debunk both of these excuses. If you are more of a visual person, watch the video below how I create a very simple financial model in only 20 minutes:
Feel free to follow the video step by step, or just keep reading. The important thing is that you create your financial model today!
We use Fluxo to create our financial model, so this is a great time for you to create an account and try it out. If you prefer to do it in a spreadsheet, it also works, but you may need longer than 20min.
1. Your Financial Model Structure
The first step to create a financial model is to create the basic tables and fields below.
P&L (Income Statement)
The P&L is always the first thing you want to create. This statement helps you explain the profitability of your company.
While for tax purposes you can build a P&L on an accrual or cash basis, a best practice for financial modeling is to always use accrual, which means: a) revenues and direct costs are allocated in the month when you deliver the product or service, and b) expenses are allocated in the month that you incur the expense (not necessarily when you pay it). Using accrual basis helps you understand your profitability better while leaving cash flow distortions (when you pay and get paid) to the cash flow.
Your revenue is how much $ you make from what you sell. At a minimum, you should break down your revenue into two components: quantity (of products or customers) and price.
Quantity - How many units of product or paying customers do you have? If you are not tracking this number, today is a great day to start. Especially if you are sharing this model with an investor, the best way for them to think less of you is by not having your revenue broken down in quantity and price.
Price - How much you charge per unit of your product or service? If your pricing is not straightforward (for example, multiple pricing tiers), create a row for each one of your unit prices and a row for the quantity of each.
Once you have quantity and price, your revenue is simply quantity * price.
Direct Costs (Cost of Goods Sold or Cost of Services)
Your direct costs are the costs related to the manufacturing of your product or the delivery of your service. For a Software business, for example, the largest line items are usually infrastructure costs (servers or cloud providers) and customer support.
If you are selling a physical product, remember that your COGS (Cost of Goods Sold) is based on how much you sell, not how much you buy (or build). For example, if you are a reseller and bought 5 items and sold 3, your COGS should be based on the 3 items that you sold, not the 5 that you bought.
Gross Profit = Revenue - Direct Costs. It gives you an idea of marginal profit, if your Gross Profit is positive it means you make money when you sell more, which is usually a very good idea.
For this simple financial plan, just add all your other expenses together in this one line item. As your business grows in complexity, you will probably want to separate line items such as Sales & Marketing, R&D, and General Expenses. But remember, a model is always a simplification of reality, you don't need to add every single expense separately, you can and should add items together to facilitate visualization of general trends.
Operating Profit (EBITDA)
Operating Profit = Gross Profit - Expenses. Your operating profit is also known as EBITDA (Earnings Before Interests Taxes Depreciation and Amortization). For most early startups, interests, taxes, depreciation, and amortization are not relevant line items, which is why for this model we end the P&L here.
Cash Flow Statement
You cash at the beginning of the month. It should equal your cash at the end of the previous month.
This should refer to the Operating Profit result from your P&L.
Your equity, debt, and grant inflows and outflows. If you have a complicated debt or equity structure, break this down further. But if all you have is some initial cash injection from yourself or friends and family, one line is enough.
Ending Cash = Beginning Cash + Operating Profit + Financing. This is how much you have in the bank at the end of the month.
Depending on your business, you might want to add line items in your cash flow for Working Capital adjustments and Capital Expenses. Otherwise, this 4-lines cash flow serves you well enough for now.
2. Input Your Actuals
Once the structure of your financial plan is created, the next step is to fill out your historical numbers.
A good reason to start very simple is that it's very common for founders to overcomplicate a financial model and find out that they don't have all the data needed to fill out their actuals.
If you don't have access to the data described in this model, you don't have a financial modeling problem, you have a data problem. Figure out that problem first, and then come back to this article 😉.
3. Add Forecasting Modeling
Now that you have the structure and your historical data, the next step is to forecast the future.
First, ignore all the lines that are made of formulas, such as revenue or gross profit. Those will be forecasted as a result of other forecasts.
Then, start with your revenue components: price and quantity. Your forecast needs to be consistent with your strategy and your momentum. If your total customers have been growing 5% per month and you are not doing anything different next month, it's probably realistic to think you are going to grow around 5% next month.
After the revenue components, you should project your direct costs, which in most businesses maintain a reasonably stable relation to revenue. You can either project it as an average of past ratios of direct costs to revenue or assume ratios for the future based on your knowledge about the business and your costs.
Last, your expenses should be projected based on your plans for the future. Are you hiring or laying off people? Are you signing up to new software subscriptions? Take those in consideration to project your expenses.
Once you added forecasts for all these items, it's usually a good idea to take a look at your P&L over time and your Cash Flow. Make sure you are not going to run out of money, if you project running out of money, you only have 3 options:
- Grow revenues faster
- Cut costs or expenses
- Raise money from investors or lenders
If you are working with more than one scenario, based on external factors such as the impact of an economic recession on your business or funding, create multiple plans and make sure projections for different line items are consistent within each of those plans.
4. Create Reports
Our last step is creating one or more reports to share with your internal team, board, or investors.
Select the key metrics that you want to look at and the most important assumptions.
In general, Revenue, Gross Profit, Operating Profit, and Ending Cash are the minimum essential key metrics that you should look at regularly.
For assumptions, select the line items that have forecasting models that impact your plan the most. For example, quantity, direct costs, and expenses.
Financial modeling is an iterative process.
You may be done for now, but keep refining your model and updating it. It will help you develop a close relationship with your business finances, which will be great for your business.
To make the most of this post and create your quick financial model free, signup now for Fluxo!