Developing a strong financial model is crucial for any business, whether you're just starting out or looking to expand. A good financial model allows you to forecast revenues, costs, and profits so you can make informed decisions about the future. Follow these steps to build a comprehensive yet flexible financial model that will serve as a guide for your business goals.
Gather Historical Data
The foundation of your financial model should be accurate historical data. Gather past financial statements, tax returns, sales records, payroll information and any other relevant data. Be sure to compile at least three years of historical data to identify trends over time. Organise the data into spreadsheets for easy analysis.
With historical data compiled, you can begin making informed assumptions about the future. Consider factors such as industry growth rates, your expected market share, price increases, salary bumps, occupancy costs, and any capital expenditures. Be realistic and somewhat conservative in your assumptions.
Project your future sales volumes based on assumptions of market size growth and your share of the market. Factor in any new products, service lines, or customer segments you intend to pursue. Build up a sales forecast by month and/or quarter. Consider seasonality and economic cycles in your revenue projections. Tie assumptions back to industry data, competitive intelligence, and your own historical trends.
On the cost side, forecast major expense categories such as materials, labour, rent, utilities, marketing, payroll, taxes, and capital asset purchases or upgrades. For each category, predict future costs based on your sales projections and expense assumptions. Consider how costs may fluctuate with sales volumes. Include inflation factors where relevant. Build in some expense padding to account for unexpected costs.
With revenues and costs forecasted, you can model overall profitability over time. Create income statements for the next 1-5 years. Calculate gross margins for your business and margins for each product or service line. Pay close attention to operating profit, EBITDA (earnings before interest, taxes, depreciation and amortisation), and net profit. Set a target for the margins and profits you want to achieve.
Find the Breakeven Point
An important element of the financial model is determining your breakeven point. This is the sales level where your gross profits exceed fixed and variable costs. Model different scenarios to find the break-even point. Look at the impacts of increasing prices or lowering costs. Consider options if your breakeven point is not financially viable.
Project Cash Flows
While income statements show profitability, cash flow statements show the actual cash running through the business. Project cash flows by accounting for timing differences between revenues (billed) and expenses (paid). Factor in capital investments and financing plans which affect cash. Calculate free cash flow after accounting for required investments to grow the business.
Attract Investors (If Needed)
For many startups and growing companies, attracting investment is key. An accurate, detailed financial model can instil confidence when meeting with investors like angel investors, venture capitalists or specialist technology-focussed global private family office like Parabellum investments. Be prepared to discuss your key assumptions and defend your market projections. Demonstrate how you plan to scale profitably.
Revisit and Revise
Financial modelling is an ongoing process. As new data comes in, assumptions may change. Review your model regularly and update it with real numbers. Rerun sensitivities and scenarios based on new information. Revise your forecasts and targets as needed. Consider the model a living document that evolves along with your business.
With consistent modelling and prudent assumptions, you can develop a financial plan to guide your business strategy. Use the model during planning sessions and share relevant outputs when making major business decisions. Allow the model to provide insights, warnings and direction as your business grows.