Economic uncertainty was already a major concern for small businesses surveyed by the NFIB, and those results reflect pre-pandemic conditions. That uncertainty is a big reason why finance leaders want to better understand how and where their money is spent, and building financial models is an important discipline for accomplishing that.
What Is Financial Modeling?
A financial model is used to forecast how the business may perform in the future. For small and large businesses alike, financial models are often built in Microsoft Excel or more advanced financial modeling software. They link the company's financial statements with formulas to forecast future financial performance based on certain assumptions. The person building the model can change the assumptions to see what effect that has on the business's plans and profit.
Assumptions are highly educated guesses rooted in historical numbers, trends, external conditions, industry and market data.
Why Are Financial Models Important to Startups and Small Businesses?
No matter the condition of the economy, businesses face challenges or discover opportunities that weren't anticipated. A supplier might be having difficulties. Or the business might be located in a part of the country susceptible to weather-related disruptions. Your largest customers may move to a competing product, or they'll double their business with you. You may discover a new business model that takes off unexpectedly. By developing a financial model that lets you analyze the results of events like these, you can be better prepared to handle those and similar scenarios should they occur.
By constructing a model that considers the business impact of extraordinary events, you can work through how you'd handle them should they occur. Developing a model that helps you understand how you would react to predictable changes will give you a head start on dealing with an unanticipated challenge.
At its highest level, your business model should help you understand what you would do if:
- Revenue continues just as it has over the past year or so
- Demand significantly increases compared to the recent past
- Demand drops significantly
The top-line implications for cash flow and product demand in each of those scenarios will have an effect on each functional area of the company, from finance to marketing. The model helps you determine the steps you would take to keep customers happy while managing the spike or fall in demand.
You don't want to be counting life jackets while the boat is sinking. Likewise, you don't want to run out of staterooms if your cruise sees a sudden rise in popularity.
A business plan that accounts for likely changes in business conditions will not only leave you more prepared; it will also demonstrate to lenders, investors or acquirers that you've thought through what it takes for business to remain successful under adverse or unexpected conditions.
Building a financial model can be intimidating for small businesses, but it's absolutely necessary. In addition to preparing for potential future outcomes, startups can use a financial model to figure out how much to charge for products or services to make a profit. Financial modeling can also be key to establishing good financial discipline by tracking performance against plans.
What's more, if a company ever wants a loan or investment, startups and small businesses will need to build a financial model to create the financial projections lenders and investors require.
Types of Financial Models
Small businesses that have been around some time can combine historical financial data with information from industry and market reports to build data models. Startups, however, often run into the problem of trying to figure out what data to use for the foundation of their financial models since they have little to no sales history or metrics on customer satisfaction. They can look to industry and market research, like Standard and Poor's (S&P) or Dun & Bradstreet, to get national averages for businesses in adjacent markets. Figures can include standard costs of revenue in every industry, the percentage of revenue attributed to direct cost of sales or what percentage of revenue goes to overhead. The U.S. Small Business Administration provides some sample financial assumptions that could be a good place to start.
The most important financial model, and the one on which every other financial model is based, is the three-statement model. The three-statement model links three core financial statements—income statement, balance sheet and cash flow statement—with assumptions and Excel-based formulas and creates a forecast for a given time period. It starts with revenue and can also calculate expenses, debtors, creditors, fixed assets and more.
An employee building a financial model in Excel will create tabs for the income statement (showing revenue and expenses), balance sheet (detailing assets and liabilities), cash flow statement (money in vs. money out), capital expenses and depreciation costs to establish a clear picture of its existing business. A finance professional can then use those historical numbers to develop key assumptions—which drive predicted results—and apply Excel-based formulas to see the projections. How will a shift in demand for your products affect revenue growth and cost of goods sold (COGS)?
On the income statement, assumptions can include revenue projections (average order value minus refunds/discounts), average order value, refunds as a percentage of revenue, discounts as a percentage of revenue, COGS as a percentage of revenue and operating expenses as a percentage of revenue.
Once the three-statement financial model is in place, other financial models can be applied to forecast the effects of various assumptions.
Sensitivity or "What-If" Analysis
This type of model shows the effects of changes in assumptions such as selling price, supply chain costs, fixed costs, forecasted sales, delivery costs and other variable numbers. Sensitivity analysis models generally change one variable at a time and then demonstrate the impact of that change. How does changing the price of packaging or the advertising budget affect the forecast? Can the company break even if it changes the average selling price?
For this reason, sensitivity analysis is also called "what-if" analysis. It challenges the person looking at the numbers to consider the reliability of the assumptions made. What happens if actual results turn out to be much different than expectations? Which factors have the biggest impact on the forecast?
This financial model is closely related to sensitivity analysis but involves changing all or many variables at the same time. A scenario analysis looks at what happened in the past and what could happen in the future, including major changes that would have a lasting impact on the company. It typically includes a base-case, worst-case and best-case scenario. Scenario analysis could be used, for instance, to model the effects of the coronavirus pandemic, a natural disaster or the loss of a critical customer on a company's total sales.
Strategic Forecast Model
Businesses use a strategic forecast model to see how various initiatives it's considering would move the needle on long-term, strategic goals. Also called long-range forecasting, this model helps organizations evaluate the impact of corporate projects, treasury initiatives and marketing and analysis plans on its long-term strategy. For example, a company may use the strategic forecast model to project the costs and potential revenue of opening a second manufacturing plant, building stores in another country or launching a new product line. It can then determine whether it's in the business's best interest to pursue those projects.
Discounted Cash Flow Analysis
A dollar today is always worth more than a dollar two years from now. If you do nothing to your business and it makes a predictable amount of money each month, you know your cash flow. If you make an investment now that will produce new revenue streams in the future, that future money is not worth as much on a dollar per dollar basis than the money you're spending right now.
Instead of investing that money in your business—by opening a new office, purchasing new equipment or buying more inventory, for example—you could invest it and get a return. You could also bank it and earn interest. So to know the value of an investment now, you need to discount the money you expect to earn in the future, which is where discounted cash flow analysis comes in.
The tricky part is deciding what that discount rate should be. Let's say you have a customer who is ready to sign a five-year contract to purchase some quantity of product, and that's the basis for your new investment. As long as that customer has a strong business, you have a sure thing—you know the company will receive a certain amount of income for five years. You can invest and use the interest rate on some other sure thing (like a five-year Treasury Bill) to determine your discounted cash flow.
If your estimated return on investments has historically been 90% of what you initially expected, then your discount rate needs to reflect that. In that way, your discount rate reflects both what you could earn if you just invested the money, plus a measure of risk based on market trends, your own history or both. You'll use that discount rate to calculate the net present value of your investment, and if it's positive, you're making a good investment.
One reason capital investment dried up in many sectors during the COVID-19 pandemic is the risk factor associated with future business. In most cases, it's very difficult to estimate a proper discount rate because, at the time, no one knew how the pandemic would go and how much it would affect business and the economy long-term.
Calculating the net present value of investments is the best way to determine whether an investment is a good one or not. But the quality of calculation is highly dependent on your ability to set the right discount rate.
Foundational Financial Models for Small Businesses
These are the models that will help you understand your company's performance:
- Financial statements: A helpful financial model that includes a forecast of the financial statements is the best way to communicate company's financial performance across banks, investors, governments, auditors or any other party.
- Revenue: This tells you how business owners are going to get paid and when they're going to get paid. Those are the things that business owners need to understand to be able to figure out how to price it, how customers are going to pay for it and how often customers are going to buy it.
- Growth margin: Out of the money that you charge customers in the revenue, how much is going to go towards delivering on the product or service and what's left over. That's going to tell you if you have money to then support and expand the business and make profit.
- Operating expenses: What's the cost to actually operate the business? What does it take from support, marketing, administrative cost, to services, software etc.?
- Working capital: Many entrepreneurs and small business owners don't realize that it's going to take capital or money to start the business or even expand into a new line of business. Business owners need to understand how much revenue you need to generate from customers to eventually make enough money to support the business after paying out the operating and gross margin.
- Investment or capital expenditures: This is usually put together when small businesses need to raise money or talk to the bank for loans or increase credit lines. Business owners need to be able to support how quickly investors could get a return on their investment.
What Does a Financial Model Tell a Business?
Having a financial model not only tells investors or lenders about the health of the business—it can improve decision-making and ultimately facilitate better business management. For small businesses, financial models can answer some basic questions to ensure the revenue model is sound.
The three-statement financial model helps a small business budget and track actual spend against that budget. This makes it easier to see potential slowdowns in cash flow and to know if and when to cut costs. And financial models help businesses plan and estimate when and how much they will need to spend to hit certain milestones around revenue, total customers or other KPIs.
For instance, Slidebean, a company that provides software to help build presentations for startups, uses two assumptions for its financial model: the number of employees and the number of active users. When the number of active users increases by a set number, the model tells the company to hire another support agent.
A financial model also allows the business to make projections in financial statements and track KPIs such as revenue growth, gross margin, operating income, earnings before income and taxes (EBIT), profit margin and net profit margin.
What Does a Financial Model Tell a Business?
Finance expert Eric Andrews says that most investors want to see a four-year plan for startups. For small businesses trying to secure a loan, some banks will ask to see projections five years out, with more detailed numbers for the first year. To build a financial model:
- Color code your model. Label assumptions blue (this is the industry standard to tell people that number can be changed). The numbers in black are linked to formulas.
- Start by generating the basic information needed for the revenue model. For a subscription-based business selling products, for example, on one Excel spreadsheet tab type in two core assumptions—advertising spend and paid customer acquisition costs. Then calculate the number of brand-new buyers. This is calculated by taking the ad spend/customer acquisition costs.
- On a separate tab, start building the assumptions needed to forecast the income statement. Begin with the assumptions about revenue/sales, COGS and operating expenses.
- To forecast sales, put in assumptions on the average order value (based on product price), refunds as a percentage of orders and discounts as a percentage of orders. Carry those out month-over-month or year-over-year across the row.
- To forecast COGS, input assumptions on product cost, fulfillment expenses, customer service and merchant fees and enter it all as a percentage of revenue.
- To forecast operating expenses, enter assumptions on headcount, salaries and benefits, as well as expenses like advertising, rent, etc.
- Above these assumptions, build the income statement. In the Excel spreadsheet, those assumptions will now be linked to formulas in the income statement to forecast revenue, net revenue, COGS, gross profit, operating expense, operating profit and net profit.
- By changing one or more assumptions, the business can see the effect of changes on key areas of the business.
Make Financial Modeling Easier With Software
Most small businesses and startups haven't automated their financial modeling. In fact, only 11% of small businesses surveyed by Robert Half said they have automated that process. Yet, a quarter said they will automate it at some point in the future.
There are clear advantages to automating financial modeling—it can handle more complex datasets and visualize projections to make them more digestible. Automation can increase accuracy and reduce the time it takes to complete the forecasts. It also allows for easy comparison of actual versus forecasted results.
But even without automated financial modeling, using technology to automate other parts of the accounting process required to create financial statements provides time and cost savings thanks to greater speed and accuracy. For instance, nearly 40% of companies with less than $499 million in revenue surveyed by Robert Half said that they have automated financial report generation. Finalizing those reports now takes 10 days, compared to 13 days in 2018.
Every startup and small business needs financial modeling. The U.S. Small Business Administration says that financial management includes bookkeeping, financial statements, projections and financing. All of these activities can offer business owners valuable guidance, enabling them to make decisions that will help their companies thrive and grow.
A study from the Federal Reserve Banks of Chicago and San Francisco found a direct correlation between financial management and the financial health of small businesses. And the better a business understands the numbers in its financial reports and the more frequently it reviews them, the more likely it is to succeed. The study found that the majority of financially healthy companies had strong financial knowledge, experience getting financing from a bank and a commitment to developing a budget compared to those with poor financial health.