A NOTE ON FINANCIAL MODELS
In the process of choosing startups to support, one of the most important factors that your potential investors will consider would be your financial model. Known as the Rosetta stone for startups, financial models predict a company’s future performance by studying its financial history — revealing the strategies and tactics of how to bring a certain product to the market. Although your business changes to some degree every year, you can still learn a lot about your revenue growth profile, cost structure, margins, and earnings growth by analyzing your business’ past performance.
Financial models give you a necessary understanding of your cash flow, entailed with its requirements and needs. Aside from the fact that this will make your lives a whole lot easier by helping you build your overall strategy in the short term while forecasting for mid to long term, your financial models also define your fundraising goals in terms of when and how much money is needed to ensure a smooth-sailing business. This will help you demonstrate how you plan to earn revenue and maximize your profitability.
Listed below are the basic requirements for a basic financial model:
- Input sheet-
- Assumptions: The basis of the whole financial model is defined by the assumption, so it must be detailed and well defined.
- Revenues & Expenses: When it comes to these, you only have to remember two things — a detailed breakup and a logic behind the numbers.
- Output sheet-
- On the basis of the assumption sheet, the revenues and expenses are derived. Based on these three sheets, the other output needs to be derived (i.e. P&L Account, cash flow sheet, working capital calculation, interest calculation, depreciation calculation and tax sheet). After the output sheet is derived, we calculate the discounted cash flow sheet (DCF) in which we include all our valuation tools, based on which we derive our valuation.
- The following are the mandatory requirements for valuation:
- Weighted Average Cost of Capital: It refers to the investors’ expectation/return out of the project.
- Terminal Growth rate for the company: Assuming the company is on “going concern” basis, this rate defines at what rate a company will grow after the projected period specified in a model.
Remember that a company’s valuation is very sensitive. See to it that it is clearly elaborated, user friendly, and self-explanatory.
Aside from making your financial model stand out from the rest, your financial model is also used for the purpose of decision making and performing financial analysis. This means that your financial model will serve as your company’s mirror in a lot of things. It will tell you if you’re in need of additional funds, how your business’ behaves towards different financial situations, what department of your company makes better returns, and clearly makes a statement on your company’s overall health.This will make you understand risk levels better, so make your financial model simple — but make sure to let it focus on key cash flow drivers and risk evaluation. Lastly, make sure to convey all your assumptions and conclusions — and you won’t have to worry about anything else anymore.
It is also important to remember that valuation at the end, is not just a science but also an art. Thus, a balanced mix of both captured in the financial model would provide a sound base for discussion with investors.