Key points for backing up the numbers in your financial model
First, regardless of the approach used to build a startup’s financial model, it’s crucial to verify the numbers with Assumptions. As a new company, historical data is often unavailable, so you need to provide “evidence” to support your projections.
This information is very important when beginning discussions with investors, as they are generally interested in understanding the reasoning behind the numbers.
Assumptions can be any source of information that validates the numbers: market research, web search volume, supplier contracts, price validation, conversion rates, bills of materials, website traffic, and so on. It may be useful to create a “data room” (for example, a Drive folder) to collect this kind of evidence. By doing so, founders are building a library to back up all the numbers behind their model and preparing for the possibility that an investor may request a due diligence process.
Financial Model Basics
Just as every industry, startup, and investor is different and values different metrics, every financial model has its own characteristics. Therefore, you can tailor the model to its user.
However, a good financial model generally includes at least:
- Financial statements
- Operating cash flow forecast
- KPI overview
Financial Statements
Every financial model includes a forecast of the three financial statements: the profit and loss statement (P&L), balance sheet (BS), and cash flow statement (CF). Financial statements are the generally accepted way of communicating financial information between companies, banks, investors, governments, and essentially anyone who needs to present and/or understand financial performance in some way. Since any finance professional can interpret financial statements, having a forecast of them is usually a requirement in almost every fundraising process.
Profit and Loss Statement (P&L)
The profit and loss statement (or income statement) is essentially an overview of all the revenue and costs a startup generated over a specific period of time, and shows its profitability.
The P&L shows several crucial performance metrics, such as gross margin, EBITDA, and net margin. EBITDA (earnings before interest, taxes, depreciation, and amortization) is very important to investors because it provides insight into a company’s operating performance and allows them to compare efficiency across different companies. The P&L can be used to compare different periods, budget versus actual performance, performance against other companies, and so on, and can therefore reveal strong or weak performance.
Balance Sheet
The balance sheet is a snapshot of everything a startup owns (its assets) and owes (its liabilities) at a specific point in time. It shows a snapshot in time (for example, at the end of the year) and is therefore different from the profit and loss statement, which shows all the revenue and costs generated over a given period of time.
Liabilities show a startup’s obligations and how it has been financed through debt, while assets show how these funds are used within the startup (for example, as capital to pay for inventory or assets such as computers and buildings). The difference between the value of assets and liabilities is equity, the capital paid in by investors that funds assets not covered by debt (assets = liabilities + equity).
Because of this, the balance sheet is always “balanced.” Shareholders’ equity represents a company’s net worth.
Cash Flow Statement
The cash flow statement shows all the cash coming into and going out of a startup over a specific period of time. The cash flow statement consists of three distinct parts: operating cash flow, investing cash flow, and financing cash flow. Separating them into these three categories provides insight into where money is coming into and going out of the startup.
Operating cash flow shows the cash inflows and outflows caused by core business operations. Investing cash flow shows changes in investments in assets and equipment. In most cases (for startups), investing cash flow will be a cash outflow (because investing in assets costs money), but in some cases it can also be positive if a company is divesting (selling assets, for example, selling real estate).
Financing cash flow relates to changes in cash arising from financing activities. Cash comes in when a company raises capital (such as loans or equity), and cash goes out when dividends are paid or interest on financing is paid (for example, to bondholders).
The cash flow statement enables management to make informed decisions about business operations and helps it prevent and monitor company debt. It also helps define a company’s investment needs and supports the timely payment of expenses and debts.
Operating Cash Flow
For fundraising purposes, financial statement forecasts are usually presented annually. For the startup’s actual day-to-day financial management, it’s useful to include an operating cash flow forecast for the next 12 months in your financial model.
Why? Because it addresses questions that annual financial statements can’t answer, such as when cash comes in and goes out.
It also gives you the opportunity to track actual performance against the expected budget each month, helping you reduce costs (if necessary) and anticipate potential cash shortfalls in the coming months.
KPI Overview
To learn more about financial KPIs, check out the next video in the series, titled: Financial KPIs for Startups