What are financial models, and why are they so important?

The best way to think of a financial model is as a numbers-driven roadmap:

• It’s a simplification. It won’t (and shouldn’t) show every detail of your business, just like a map won’t show every leaf and stone.

• A model should reflect the company, not vice versa. If you found a road on a map that didn't exist, you wouldn’t start paving it. A model should never restrict your strategy and vision: it should be adapted to accurately reflect them.

• To be useful, it must be readable/accessible. It should follow certain conventions (basic accounting rules), but also should fit a cohesive narrative that resonates with stakeholders. If you propose certain milestones, benchmarks, and performance indicators, these should appear in the model within their respective timeframes.

Four reasons why financial models are so important:

1. It’ll help you understand the key levers of your business

This is key for swift, efficient decision making.

For example—increasing pricing will generally lead to more revenue. But while some customers will accept higher prices, others will leave if there is a price increase. Should you price down at first to capture the market, or will that erode your future profitability? 

Maybe hiring software developers will help you perfect the product, but investors will want to know if you have an effective go-to-market plan, for which you need sales personnel. Which should you prioritise, or do you have enough capital to do both? 

2. It’ll help you keep track of your company’s financial achievements and health

Two key questions you’ll have to answer pretty much every day:

“Am I growing enough?” Properly recording historical volumes, revenue, and growth metrics will help establish a track record to assess your strategy and guide future initiatives.

“Do I have enough cash?” Accurately tracking costs (or “burn”) and external cash inflow will help you assess and control your runway, prioritise capital investments into strategy venues, efficiently time your fundraises and optimise your capital structure.

3. It’ll help you test and iterate on key assumptions

Unless you’re Paul the Octopus, trying to predict the future is a fool’s errand. So being aware of and preparing for different scenarios is critical to any decision-making exercise. A well-built, flexible model will allow you to quickly shift between scenarios and modify assumptions, adding a new layer of information to in-depth strategy discussions.

4. It’ll help you effectively communicate with key stakeholders 

Among other uses, financial models are also powerful sales documents, which speaks volumes about a founders’ business acumen and commercial capabilities. Assumptions should be well-backed, but ambitious; growth expectations should be sensible, but compelling; and strategy points should be purposeful and well-timed. Little is more compelling to investors (and partners & future employees) than a founder who can show, not only qualitatively but concretely, why their success is inevitable.

How to build a financial model

Let’s get to it: how do you actually build a simple financial model? The easiest way is to split it into three core components, and add onto them as needed based on the rising complexity of your business over time. These components are: 

Here’s a basic model you can pair with the below explanations for some extra clarity.

Part 1:

The Cockpit aka the Assumptions Sheet

This is where all your core model assumptions should live, and this is where you will be spending nearly all your time once the model is completed. Taking time to properly format and structure the assumptions sheet will make your life significantly easier. 

Residents of the assumptions sheet include:

1. Revenue assumptions

a) Volume assumptions - number of customers or items sold, and expected monthly growth rate 

If you’re calculating your number of customers from a marketing funnel (e.g. website impressions > sign-up rate > conversion to paying customers), as in the template model, funnel assumptions should sit with volume assumptions.

e.g. I have onboarded 20 clients on my SaaS platform so far and expect to grow that number by 10% every month (next month I will have 22, then 24, 26, and so on).

b) Pricing assumptions -  how much you charge for your product

This could be as simple as a unit price (e.g. £20 per item) or as complicated as a tiered SaaS subscription model (e.g., £10/month for a personal subscription, £1,000/month for a small enterprise subscription, £5,000/month for a large enterprise subscription). It can also be a commission rate (e.g., 15% commission on a purchase made through the platform).

2. Cost assumptions

This includes direct costs (such as cost of materials per unit produced) and indirect costs, or “overhead” (sales & marketing, general & administrative and others).

e.g. £5 of materials + £2 of shipping per item sold; 15% of monthly revenue on marketing costs; £300 per employee on office space; £150 / month flat rate for insurance; etc.

3. Cash flow assumptions

This includes your current cash balance and your expected fundraising round amounts.

e.g. I currently have £150k of cash in the bank; I expect to close a £1m pre-seed round in December 2021; then a £3m seed round in December 2022

4. Personnel assumptions

Though they are technically part of the cost assumptions, personnel costs (i.e., salaries) are usually by far the largest cost component at this stage of a business. It’s handy to keep them in a separate sheet to help keep track of headcount and strategise around future hiring decisions.

Part 2:

The Engines (aka ‘Where the Maths Happen’)

The engine sheets are where you work the assumption numbers into monthly financial results. It’s an exercise of logic and basic accounting, backed by a core understanding of your business model. Thankfully, google can supply several examples of best calculation practices, usage of excel formulas and typical model structures. 

The key is to take your time to automate things properly - so once you are done, you will only come back to these sheets for structural additions.

Meet the engines:

1. The Revenue Sheet

Volume and price can take multiple formats. You can also have multiple segments and/or revenue streams—one-time purchases, subscriptions, commission—meaning in the same model you can have a few different forms of Volume x Price. Think through each of them separately, add them together at the end.

2. The Costs Sheet

COGS are direct costs related to the physical products you are selling (such as the cost of fabric for making a piece of clothing) and are calculated on a per unit sold basis. Service companies (such as SaaS businesses) rarely have COGS.

For overheads, in general, you can have the following cost “categories”:

• Fixed rates (e.g. insurance, rent) - anything that is charged as a fixed contractual amount on a monthly or yearly basis 

• Growing costs (e.g. hosting services, , direct marketing) - you will usually have an initial fixed value for these, accompanied by a “growth rate” which you assume is needed to support the future scaling of the business

• Variable costs based on revenue (e.g. COGS, certain advertising costs) - anything that is estimated as a % of your achieved revenue 

• Variable costs based on personnel (e.g. travel, entertainment, hybrid workspaces) - assume a cost per employee, and multiply by headcount

3. Cash flow modelling

Cash flows should be modelled as simply as possible (see below). Starting from the current cash position of the company:

1. Add any incoming investment cash and operating profit

Note: because cash flow modelling at this stage is so simple, you can include these calculations directly in the summary page, right underneath the financial summary (as in the template provided).

Part 3:

The Summary Sheet

This effectively paints a picture of your company development for the next 1-to-3 years. In its simplest form, a summary sheet should show two things:

1. Total Revenues – Total Costs = Operating Profit / Loss

2. Existing Cash + Incoming Investment (+/-) Operating Profit / Loss = Cash Position

It’s worth having a more detailed summary sheet, so that you don’t have to sift through your engines to find additional information. This should include:

• Volume (by segment or by type, if applicable) - while pricing is internally defined, volume varies based on external reception of various strategic choices. Looking at volumes separately can give you tons of insight on how recent strategies have been performing

• Revenue (by segment or stream, if applicable) - this is the key metric for any early-stage business. Looking at it by segment/stream provides insight into how each chosen vertical is performing separately

• Personnel expenses - should always be listed separately, given they are almost always the largest cost. As your team develops, it can be useful to split personnel expenses by function/team

• Expenses (broken down by size/importance) -  it is not critical to break down expenses (apart from personnel), unless one of them is significantly larger than the others or provides meaningful insight into the workings of the business