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.

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).

Top tips for building financial models

Automate EVERYTHING

Only hardcodes (pure number cells) in a model should be in the assumptions tab. Everything else, particularly in the engines tab, should run automatically. It takes time to set up formulas and check all the links, but it will save you tons of time (and reduce errors) should you need to change any assumptions or run scenarios. 

The best guideline to go by: once the model is done, the only thing you should be touching is the assumptions tab (aka the cockpit). You will only touch the engines to modify the model structure (e.g. add new revenue or cost lines).

Use number tying

All documents (teaser, pitch deck, any appendices, model, data room docs) should “speak” to each other and tell a cohesive story—which includes showcasing the same numbers. Once you’ve finalised your fundraising documents, look through them together in detail and make sure all numbers and metrics mentioned are accurately depicted in the model within the correct timeline.

Look out for…

• Any GMV, ARR, MRR, customer volume or other metrics cited as milestones

• Any specific hiring timelines explicitly mentioned

• Any significant inflow / outflow of cash (e.g. fundraises, runway, etc)

Label, label, label!

You might know what that 43.7% on cell D45 means, but that doesn’t mean anyone else will.

Get in the habit of putting any hardcodes in a separate cell in the assumptions page, and labelling them. It can be something as obvious as “Months to a year = 12” or as critical as “Premium Commission Rate (per user) = 15%”.

Use comments to your advantage

The comment box (Shift+F2) on cells is a great place to jot down any implicit assumptions, comments on the formula used, or anything else that may be helpful (to you and others) in understanding your modelling decisions and assumption choices.

Colour-code your cells

Do the following as you go along:

1) Format all your hardcodes (pure numbers) BLUE

2) All in-sheet formulas BLACK

3) All links to other sheets GREEN

4) Anything suspicious (mixed hardcode/formula, links to other workbooks) RED

This colour code is widely known among people in the financial markets, and it works to indicate which cells you can safely modify (blues), which you shouldn’t touch (blacks and greens), which are simple formulas (blacks), which have a detailed calculation elsewhere (greens) and which may cause some confusion (reds).

Tips for forecasting

The general rule of forecasting: the closer you are to the present, the more “proven” your expected numbers need to be.

• Up to 18 months (or up to your next funding round) - make reasonable assumptions based on existing or imminent revenue lines. Investors will want to know what their capital will be used for, and milestones before the next fundraise.

• 18 months to 3 years (aka the “Realm of Healthy Scepticism”) - investors may question or discount projections here, because of the higher degree of uncertainty. With that in mind, show vision and ambition - indicating the high growth prospects, innovative new business verticals (and revenue streams) and strategic advantages you plan to achieve.

  
  

• Beyond 3 years - long-term business plans at this horizon risk being judged as either a) unexciting for being too conservative or b) unrealistic for being too ambitious. It’s incredibly difficult, especially at pre-seed / seed stages, to tell what the business will look like that far ahead. If investors ask for this length of forecasting, you should try to gauge any specific long-run concerns through strategy conversations.

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