Business decisions should always be driven by data. The best financial leaders consistently analyze where their company needs to go and what it needs to do to get there. Although that’s often easier said than done.
Startups tend to have jagged growth patterns initially, due to their large influxes of external funding and unique products. It’s not always a simple thing to manage their cash flows and revenue growth over time.
Fortunately, there are some powerful strategies you can use to help leverage your financial data: financial modeling, forecasting and budgeting.
This article will explain what each of these mean, why they’re important and how you can start implementing them in your own business.
Let’s dive in.
A financial model is a tool used to represent the entirety of a business’s historical and future performance. The future is, of course, based on a set of assumptions, and each of the accounts is connected so you can easily alter one and see its effect on the other.
Once built, the model can be intentionally manipulated using forward-looking techniques (including forecasting and budgeting) to provide insight into the growth of the company. Financial models are often constructed in Excel spreadsheets, though many modern companies are switching over to more streamlined software.
The most fundamental form of a financial model is the Three Statement Model, which includes an interconnected balance sheet, income statement and cash flow statement.
It’s a necessary base for the creation of more complicated models, like the Discounted Cash Flow (DCF) Model which can be used to value your company for a potential investor.
Financial models are a powerful tool for many reasons, but the most important by far is that they enable your business to make exponentially more effective financial decisions.
Without an in-depth financial model, your startup’s ability to plan for the future is extremely limited. Businesses that make decisions without an accurate understanding of what impact they’ll have on their financials are asking for trouble. They’ll very quickly run into cash flow problems, often spending too much or in the wrong places.
A financial model allows you to test multiple scenarios of the future, analyze the potential outcomes and make strategic decisions using that information.
Now, let’s take a quick look at how you would build a financial model for your startup.
Financial modeling and forecasting are intimately linked and often confused for one another. But here’s the distinction: the model is the tool, while forecasting is its primary purpose.
Forecasting is the use of historical data and pivotal assumptions about the future to predict your business’s future performance.
Surprisingly, the key to creating an effective forecast often lies more in the assumptions than anything else. Those assumptions can swing the projected results wildly and are usually what make or break the forecast.
To effectively forecast your company’s future, you need to have a deep understanding of your company’s business model, your market, your competition and all the other external factors that might affect your growth.
Forecasting is the real reason that financial models are built. Models provide a framework for understanding your business, but they don’t mean anything unless you use them to plan for the future.
Forecasting effectively allows a startup to:
Budgeting is a subset of forecasting that is hyper-focused on expenses and other cash outflows. It’s one of the most common ways of using the Three Statement Model, though it relies more on the income statement than anything else.
You’ll need to create different budgets for your company at each stage of your growth.
For example, before you’re bringing in any revenue, you’ll want to create a budget simply for the costs to get your product or service ready for sale. But once you’re bringing in revenue, your operations will expand, and you’ll need to refine your budget to account for these new expenses.
A budget is an important tool for a startup at any stage, but it’s particularly useful for companies that are concerned with their cash runway. This might be during periods of low revenues or thin margins.
When your startup has evolved past those difficulties, your budget becomes a more analytical tool. Successful financial teams often have monthly or quarterly meetings to compare their budgeted spending to their actual spending, so that they can discover problematic areas and adjust accordingly.
Finally, let’s take a look at a quick outline for building your startup’s budget.
Even for the most talented founder, it can be difficult to manage a startup’s financial health singlehandedly. Unfortunately, hiring a team of financial professionals, or even just a Chief Financial Officer, can be an extremely expensive investment.
Unless your startup is already firmly established and highly profitable, it’s unlikely that that expense will fit in the budget. But there is a way for you to get the best of both worlds.
Consider taking advantage of outsourced CFO services. You’ll love the flexibility to consult with a CFO as much as you need, without the expense of bringing on a full-time resource.
Founder’s CPA can help you with your financial modeling, forecasting, budgeting and more. Check out our free consultation to get help with your startup’s finances today.