As a startup founder or entrepreneur, building a successful business is a challenging feat. From getting off the ground to securing funding to managing daily operations and growth strategy, the list of tasks can seem daunting.
But one crucial aspect often overlooked amid all this hustle is creating a financial model for your startup. A model is a foundation for reducing uncertainty while making important decisions and forecasting your company's future performance.
Many founders shy away from financial modeling because it can be intimidating and complex. This post breaks down this essential steering tool for any business.
Understanding the Basics of Building Financial Statements
Financial statements are crucial for any business. Understanding the basics of building financial statements ensures a solid foundation for decision-making and helps track progress and growth.
Financial models typically include the balance sheet, income, and cash flow statements. They paint a comprehensive picture of a business's financial health and trajectory by combining:
- Historical data
- Common metrics
- Budgets and forecasts
- Industry benchmarks
A robust financial model includes revenue forecasts, expense estimates, projected profits, and cash flow statements. When making investment decisions, it's also essential to have key performance indicators (KPIs) such as return on investment (ROI) and return on equity (ROE) to measure the profitability of your various options.
Ultimately, the success of a financial model hinges on the accuracy and thoroughness of your assumptions. By taking the time to consider all relevant metrics and components, you can create projections that help you reduce uncertainty, make informed decisions, and plan for the future.
Financial Modeling Dos and Don'ts
Following a few fundamental principles ensures your models are robust, scalable, stable, and easy to understand.
Try to streamline your financial model as much as possible while including the necessary data. Focusing on the following core principles will make your models more functional, efficient, and actionable.
Complex calculations that take hours to decipher can confuse you and potential internal (and external) stakeholders.
Simple and consistent is always better
Simple and consistent is vital in many aspects of life – from websites to cocktails. The same applies to business.
Why? It makes everything easier to understand and navigate. As your business grows and financial models get more complex, it takes increasingly more effort to understand the differences between the various components.
Standard principles like always showing periods left to right and keeping income statements above and assumptions below help avoid errors.
Color coding and right-alignment
When it comes to organizing data, color coding and right-aligning all numbers are two methods that can make a difference.
Consistent colors help to visually distinguish between different categories. They are a great way to ensure that information is easily digestible.
For example, always showing hard coded numbers in blue, references to other cells in green, references to another file in red, and dynamically calculated formulas in black makes it easy to understand what's happening in your spreadsheet.
Meanwhile, aligning data to the right creates a tidy, structured look that can make tables and spreadsheets much more understandable.
Best of all, these tactics are easy to implement. With a little effort, you can present your data in a way that's both aesthetically pleasing and informative.
Consistent formulas for easy extension of time-horizons
The initial setup of your formulas can be challenging. But once they work, you need to be able to copy and paste to the right to extend your time horizon.
This trick ensures that you're employing the same calculation for each analysis period and can readily project well into the future.
Using the same sign convention
When it comes to conveying information, consistency is critical. One area where this is especially true is in the use of sign conventions. Using the same sign convention helps avoid confusion and miscommunication.
Although there isn't necessarily a right or wrong way, many individuals find working exclusively with positive expenses more intuitive and straightforward. This convention also makes it easy to remember to subtract from sales and gross profit.
Further, one effective method is to break down your expenses into specific categories, such as overhead costs, supplies, and salaries. This categorization will allow you to quickly identify which expenses to deduct from your sales or gross profit.
What Not to Do in Your Model
Beyond obvious errors like using poor-quality data and over-complicating your calculations, there are a few common pitfalls to avoid when creating a model.
Don't hard code numbers embedded within formulas
Hardcoding makes the formula less flexible and more prone to errors.
For example, if you have a formula that calculates the average of a set of numbers, hardcoding a specific set of numbers within the formula could cause issues if you need to change those numbers later. Instead, use cell references to update the formula easily by changing the values in those cells.
Never use the same input from multiple locations
Using the same input from multiple locations can lead to mismatched assumptions or inaccurate outputs. Imagine having two input fields for your monthly recurring revenue growth rate. If one is updated and another isn't, your model might consider two different rates, which won't make sense.
Don't link between files
Referencing information in an external file can be risky. If someone moves the reference file, you might break the links, leading to a model that doesn't work.
Alternatively, a modified referenced file might change the assumptions in your financial model without your knowledge.
Keeping everything in one document or file will eliminate the need for linking and ensure your project stays organized and easy to navigate.
Don't hide sheets or rows
It can be tempting to hide sheets or rows to make things look more organized. Initially, it may seem like a good idea, but it can cause more problems than solutions.
Anyone accessing your spreadsheet might struggle to understand the model's projections. Plus, if you accidentally hide important information, it can be challenging to audit what you've done in the past.
Instead, consider using filters, color-coding, or conditional formatting to highlight important data or simplify your view. Your colleagues (and your future self) will thank you!
Ask a Professional for Help
Building a financial model may seem overwhelming. But by understanding the basics and following some fundamental principles, you can create a scalable, stable, and easy-to-understand model for you and your stakeholders.
Remember to keep it simple. Consistent formulas, sign conventions, color coding, and right alignment all enhance your model's readability and help avoid errors in calculations.
Of course, you can build a working financial model on your own. However, having a professional review, like with the startup finance experts at Founder's CPA, of such an essential tool can improve your confidence in the model and its robustness.
Contact us today to start creating a financial model to set your business up for success.