Episode 2 – Financial Modelling Fundamentals
Welcome to Episode 2 of Five Minute Finance for Founders (wait why no Episode 1?! Let me know when you’ve figured it out!)
Your time is valuable, so we won’t waste it, that’s a promise!
Today we’re going to talk through the basics of financial modelling, useful on so many levels from thought experiment, to forecasting, to raising your series a – but as your venture grows, so does its complexity, and with it your model. With that said, let’s get stuck in!
- Who needs a financial model?
- Why do you need a financial model?
- What does my model need to contain?
- Where do I even start?!
The Who: In general models are critical to founders and the c-suite in general. For the CEO and CFO in particular, they’re essential as they respectively build the venture, raise capital and allocate that capital where it’s going to produce the most productive returns. Externally they’re used by anyone wanting to invest in or lend to the venture as well as the board of directors who will help guide the exec team as they seek to grow.
The Why: There are a whole bunch of reasons why you might want to build a model. But let’s cut to the chase, the number one use case for building a model in any early stage venture is to help you raise capital. Doesn’t matter whether you’re raising equity or debt, at some point, somewhere, someone is going to ask for your model – and then adjust it based on their own assumptions! It’s the tool they’ll use to assess your venture’s growth path, cash profile and needs, ability to repay debt or likely return on investment.
The What: So what actually needs to go into your model? Let’s assume that we’re only talking about building one to attract investment or raise some debt, here are the key things you need to make sure are in it.
A profit and loss (income) statement that shows business performance on a month by month basis over at least the next 3 years – we normally forecast over 5 years giving room for bigger picture strategies. This statement should show:
- Where your revenues are coming from.
- What your gross margin / gross profit on those revenues is.
- What your operating costs are.
- What your EBITDA (earnings before interest, tax, depreciation and amortisation) are.
The next, essential, statement is the cash flow statement. It’s easy to fall into the trap of assuming that profit and loss is equivalent to your cash flow; unfortunately that’s just not the case – and when you’re out there looking for capital from savvy investors, they’ll pick you up on that straight away. Your cash flow should show:
- Cash income (appropriately forecast to allow for cash sales, credit sales, discounted sales etc.).
- Direct costs associated with cash income (think cost of sales, performance marketing costs, hosting costs, card processing fees etc.)
- Operational cash flow such as headcount costs, rent, brand marketing, legal, accounting and other general and administrative costs.
- Cash flows arising from indirect taxes such as VAT, GST or sales taxes.
- Your net operating burn (all your inflows less all your outflows).
- Your opening and closing unfunded bank position.
- Your net cash requirement – that is the money you’re venture is going to need to reach its next milestone.
Remember that there will be timing differences between your profit and loss and cash flow, because you don’t always pay for stuff as it happens, you may have quarterly rent or annual subscriptions. You may buy or sell on credit, all of this shifts your cash flow.
But there are two tabs that we think are critical in any financial model – the Input tab which basically maps out your logic around what drives your revenues and costs and the Output tab which summarises on a quarterly or annual basis the profit and loss and cash flow statements.
The input tab in particular is a whole topic on its own which we’ll cover in the future as the assumptions that go into it are what informs anyone looking at your model how you think about your business.
Finally, where do I even start? Look, we get it, fiddling about with Excel and Google Sheets feels like a complete waste of time when you’ve got a million other priorities, not least building your venture. We recommend starting off by thinking of your financial model as your pitch deck in numbers, it’s got to tell the same story and arrive at the same conclusions and outcomes.
From there, build out your input page structuring it so that you have your revenue inputs, growth and unit economic inputs and overhead inputs separated out so they’re easy to follow. All of this will then feed into tabs to generate the outputs that will feed into your profit and loss and cash flow statements.
As a rule of thumb, we advise anyone building their own model to keep it simple unless they’re really comfortable with using tools like Excel and Sheets; and if you think your time is best spent elsewhere, there are plenty of experts out there who can help you build what you need.
We’ll leave you with this one parting thought though, in early stage ventures, the only thing we can tell you with 100% certainty is that any financial model you build will be 99% inaccurate! It’s the nature of the beast when you’re forecasting in uncertainty.
In Episode 3 we’re going to start looking at cap tables, what’s key, what’s not and when it’s time to move away from a spreadsheet to something more sophisticated.
Finally, because we know there’s no cookie cutter approach to venture building you can let us know what you want us to talk about by emailing us at [email protected] and if you want to ensure you get this straight to your inbox every week, just sign up here.
Right, back to building!
Aarish and the EmergeOne team
