Your financial model is your startup road map. Just as you wouldn’t hop into your car without your GPS to head off into the unknown, neither should you proceed with your business without going through the exercise of creating your financial model. Long before you’re reaching out to potential investors, you need a working financial model.
So what is a financial model? At its simplest level, it’s just charting your cost and revenue projections for right now and for some time into the future (I recommend a 3-year model—no more than that).
The biggest purpose your financial model serves is to help you to understand your cash
Really know your burn. It is essential that you know how long your money is going to last and what milestones you are going to be able to achieve with that spend.
In addition to being an indispensable cash management tool, your financial model can also help to:
1. Provide a comprehensive financial picture.
Presumably you’ve started a business with the goal of making money. It’s pretty tricky to make money without understanding where that money is coming from and what kind of cost investment it will take to become cash-flow positive. A financial model is big picture thinking. You take all the pieces—costs, revenue, cash-flow summaries, profit and loss statements—and piece them together to see the big picture.
2. Give insight into your business model.
A financial model forces you to think through all of the variables that affect the potential profitability of your business from staffing and professional service requirements to sales and marketing costs. Your financial model serves as a foil to your business model, highlighting its strengths and weaknesses. This insight gives you valuable information that you can use to improve your business model.
3. Clarify your decision-making process (short-term and long-term).
Making decisions on gut is only going to get you so far. In reality, you need the numbers—and the hard truths they tell—to make essential business decisions about expenses, hiring, product development and every other important determination.
4. Force you to evaluate key performance drivers.
Your KPIs (Key Performance Indicators) are the critical items that you need to monitor in order to build a profitable business. The KPIs that you monitor will depend somewhat upon your business, but should include such things as revenue, Customer Acquisition Cost (CAC), and Life Time Value (LTV) of a customer. Creating your financial model forces you to go through the exercise of evaluating which KPIs are significant—and which are less so.
5. Validate your assumptions.
Piggy-backing on the KPIs, another way of looking at it is that creating your financial model forces you to validate your assumptions. For example, when do you expect to start selling your product? How will your product be sold? Are you assuming your expenses will rise as your sales rise? Your financial model gives you the opportunity to trace these assumptions and determine whether they hold up or fall apart. Because your financial model isn’t a one-and-done exercise, the ongoing efforts to create your model sets up a valuable iterative process in which you are continuously improving your assumptions.
6. Give you the leverage of an accurate baseline valuation.
If you create your financial model right out of the gate, you have a financial trail that you can refer back to—where were you and where are you now? Historical financial models give you something against which you can continually gauge your progress and assumptions—which keeps you on the right track.
7. Satisfy investors.
And yes, a financial model also exists to satisfy potential investors. They want to know that you have thought through the numbers, understand them intimately, and have clear—and realistic—financial goals.. It also lets potential investors know why you’re asking for the funds that you are asking for—and how much they can expect to get as a return on their investment
Your financial model is so much more than a mere accounting exercise; it’s an opportunity to show, with numbers, the very real potential of your business—and to proactively manage your growth. This quote from Guy Kawasaki sums it up best: “The point of financial projections is to tell a story with numbers—a story about opportunity, resource requirements, market forces, growth, milestone achievements, and profits. Your job is to create a numerical framework that complements and reinforces the vision you’ve painted with words.”
How do you use your financial model? Tell us about it in comments below | Images Via Shutterstock