Most startups don't have the luxury of having an in-house financial analyst. Unfortunately, that means founders are left to their own devices when understanding and predicting their company's future financial health.
Using the wrong financial model can lead to inaccurate projections, putting your startup on the wrong course. Without the means to accurately predict the future, you won't be able to make informed strategic decisions. Underestimating cash needs or over-forecasting revenue can be disastrous for a young business.
Thankfully, various models are available to help founders better understand their startup's financial situation. From budgets and forecasting to valuation, utilizing different financial models can provide decision-makers with the data they need to make informed decisions.
What Are Financial Models?
Financial models are mathematical representations of a company's past and present financials used to predict the future performance of a company. They're used to forecast cash flow, budget for expenses, and even assess the value of new investments.
These models can come in many shapes and sizes, but all provide an overview of how various factors may play out in the future. Amid the current economic slump, these models are fundamental for startups to rely on when making decisions.
They can also help startups understand where they stand and plan their next moves accordingly. They also guide pricing, investments, acquisitions, and valuation decisions.
Due to their complexity, these models often require specialized knowledge and understanding, which is why most startups seek outside guidance. The resources necessary for business financial modeling require time, effort, and resources, so having an experienced financial advisor to help is often invaluable.
Different Types Of Financial Modeling For Startups
While some models focus on projecting future cash flows, others may be better suited for budgeting or evaluating strategic investments. Depending on your company's needs, these models can be used to provide invaluable guidance.
Here are a few of the most common types used by startups:
3 Statement Financial Model
The three-statement financial model projects a company's financial performance over a period of time. The three financial statements you'll use are the income statement, balance sheet, and cash flow statement. Using this model, you can capture the cumulative impact of all past financial decisions. This tool can also test future scenarios and different sources of money.
For example, if your customers are already pulling back due to the recession, you can map out different amounts of recurring revenue loss and how this affects your budgets.
Discounted Cash Flow Model
Often referred to as DCF, the discounted cash flow model determines the value of a company based on its future cash flows. Investors use this model to see the company as an investment, not a functioning business.
Budget Financial Model
The budget financial model predicts a company's expenses and revenues. It factors sales, operating expenses, and cash flow to provide an overall financial picture. Financial advisors or founders can then make adjustments for the following fiscal year based on the data provided by the model.
This model predicts a company's future performance based on past trends and current market conditions. These templates use your historical data and industry trends to make accurate projections. In addition, financial forecasting helps startups understand the external factors that may impact their business, such as changes in consumer spending, economic growth, and more.
Pro Forma Financial Model
This hypothetical model projects future values to predict financial performance over a period of time. Income statements, balance sheets, and cash flow statements provide data alongside assumptions about prospective financial performance. By assessing different scenarios, you can prepare for multiple ‘what ifs’ rather than being surprised by them.
This model gauges the impact of different variables on a company's overall performance. It helps startups assess the outcomes of different decisions and identify areas for improvement. You can adjust variables in the model and see what kind of impact they have on your financials. Some variables include consumer spending, economic growth, or interest rate fluctuations.
This model evaluates different scenarios and their potential impact on your business. It requires you to consider each financial decision's most likely, best-case, and worst-case scenarios. Using estimation models and quantitative analysis, you can assess the potential outcomes of each scenario and plan accordingly. Input variations include revenues, expenses, and capital investments. With scenario modeling, you can predict the future performance of your business with greater accuracy.
This model assesses the impact of a merger or acquisition on both companies involved. It helps startups understand the implications of combining two businesses and evaluate the potential financial benefits. You'll need hypothetical assumptions and accurate valuation data for each entity to accurately project the impact of a merger or acquisition.
An IPO valuation model helps startups evaluate their business from an investor's perspective and determine the right price to offer shares to the public. To perform this analysis, startups must look at market trends, the competitive landscape, and financial projections.
An LBO (leveraged buyout) model determines the feasibility of a company's acquisition by private equity firms or other investors. This model considers how much debt the acquiring party will take when making the acquisition. It bases the analysis on assumptions about the target company's financial performance, cash flow, and operating metrics.
Sum Of The Parts Model
The SOTP model evaluates the value of a company's separate divisions or businesses and how they stack up against one another. This helps startups get a holistic view of their operations and identify areas that need restructuring or improvement. To measure the individual value of each division, startups must also include assumptions about market conditions and the growth potential of each business.
A consolidation model combines financial data from multiple entities into one comprehensive report. This model helps startups understand their subsidiaries' performance and make more informed decisions. Revenue, profit, and expenses work in the model alongside productivity rate, operating metrics, and other key figures.
How To Choose Your Financial Models With Purpose
Each of the models listed above can help startups achieve their goals. But why do you need different types of models? The answer lies in understanding the purpose behind each model and determining which one best suits your individual needs.
Understanding your business's financial health involves more than just crunching numbers; it takes careful thought and analysis. It's essential to consider the different types of financial models available, as each can provide an invaluable tool for making informed decisions.
To find the best financial model for startups, start by assessing where you currently stand and what specific data or insights you need. Utilizing a combination of models can help you create a comprehensive financial picture of your business while also allowing you to identify risks and opportunities specific to your industry.
Models represent the foundation of your financial decision-making. Even though the initial learning curve can be steep, startups that take the time to understand and leverage different models will be more likely to achieve their goals.