Financial Modelling Blueprint
It is a vital document in the fundraising process and is created on Excel to project a business’s financial condition and performance in the coming years. The projections are usually based on the organization’s financial track record, assumptions about the future, and requires preparation of financial statements such as income statement, balance sheet and cash flow statement
Why is a financial model important?
The financial model is an important document required in the investment process which provides the information about the current financial analysis and future projections of the company. The company executives can utilise the financial models to make decisions about:
- Fund Raising (equity or debt)
- Mergers & Acquisitions
- Organic growth of the business (effects on the top-line)
- Scenario Planning & Projections
- Utilization of funds (capital budgeting)
- Valuation of the business
Reason investors required a Financial Model
Effectively Understand Your Strategy
The reason is to understand your business strategy and your execution plan because it includes key business decisions like hiring employees, allocating marketing budget, liquidity, and solvency. Many entrepreneurs are pitching business ideas only with market data. Typically there needs to be a slide that addresses the market size & analysis, the management team, the problem statement of the company, and the market strategy.
Investors are interested in Cash Flow
Although being an accountant or financial wizard may not be mandatory, you should understand cash flow. When you are creating a financial model, it must be created from the perspective of cash outflows and cash inflows. Your model must address the necessary cash flow required to keep your business running. Cash flow analysis helps an investor to understand what would be the free cash flow for equity holders. The financial model helps them analyze the cash flow generating capabilities of the company. The better the cash flows of the business, the higher the chances of an investor is interested. Before creating your financial model you must have clarity about the following:
1. Revenue Streams – What are the drivers of your revenues? Are you selling multiple products/services?
2. Pricing – Pricing strategy would reflect directly on the revenue of your business. Does your business have a subscription model, fixed prices, variable pricing etc?
3. Customer – Are you customers businesses, direct consumers, or government?
4. Customer Acquisition – This is a vital aspect of a business plan & financial model because your customer acquisition strategy will be translated into the utilization of funds.
The majority of the investors look at the profitability of the company or the profit-making ability of the company. The financial model provides them every line item & the common size (percentage of revenue) which helps them analyze the what are the pain points of the business. Although your revenue may be high the investors want to focus on the cost of goods sold (COGS), gross profit margin, and operating expenses, earnings before interest & taxes (EBITDA). For eg, in your financial model, if your gross profit margin reduces in year three by 3%, this would mean that due to the increase in the volume of business the direct expenses also known as the cost of goods sold have reduced which have increased your gross margin. Higher profitability ratios, the higher the chance of getting an investment.
Many entrepreneurs follow the strategies used by unicorns or reputed startups, which is, taking on a large amount of debt and utilizing the funds to grow the business. This increases the financial leverage of the company. Although leverage is definitely beneficial to improve margins, leverage is a double-edged sword. In the initial stages i.e. in the survival phase of the business cycles, taking on high amounts of leverage would reduce the liquidity & solvency of the business. The single most important aspect for investors is liquidity. While your financial model will mention your cash requirements for each month, the inability to generate the necessary cash flow would be considered a red flag for your business.
Therefore, the financial model is not just another spreadsheet. The model is a crucial document in the decision-making process of an investor. It’s a tool that will be able to communicate the strategy, profitability, and long-term vision of the company. The financial model is the document that ties the pitch deck and business plan together to create a holistic view of your business and provide complete clarity to your potential investor.
Common Problems in Financial Modeling
- Complex Excel Formulas
Many entrepreneurs make the financial model overly complex by adding unnecessary formulas. A complex financial model with numerous formulas may seem more accurate and may be appreciated by your seniors, on the contrary, it might be very difficult to understand. A Financial Model is very similar to a UI/UX of an application, the application and ease of use are essential. Therefore, simplicity is an important feature of a great financial model.
- Errors & Missing Excel Add-ins
If auto calculation is set to enable iterative calculation & manual, the number of spreadsheet errors that you would experience would be very high. Every finance individual would need to make sure the common Excel add-ins are integrated as many of the excel formulas depend on it to work. These features would help you ensure accurate calculations.
- Cell Format discrepancies
It is essential to ensure all numbers are written in thousands, lakhs, or crores on the entire spreadsheet to maintain consistency, to avoid misspelled naming convention of business units, projects, or assets. Moreover, you must be mindful of the addition of conditional cells to guarantee consistency.
- Hidden Cells, Rows, Columns, or Freeze Panes
The financial model that would be created should avoid hidden cells, rows, columns, and freezing panes to ensure no important elements are missed. This would help you avoid making inaccurate changes to the complete worksheet.
- Inculcated Macros
The majority of the financial model users would not have advanced knowledge of VBA code or macros. Thus, while preparing a financial model for investors or general audiences, be mindful of the inclusion of macros into the model.
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