What is financial modeling?
Financial modeling is an excellent tool to forecast the future economic development of a company. It is fundamental for a sophisticated business plan. It helps make investment decisions, plan resources, curb risks, and achieve overall better business results. Financial modeling involves either creating a model from scratch or maintaining the existing model by implementing newly available data.
With these 5 principles of financial modeling for startups and SME’s, you will understand the predictive model’s essentials, provide a holistic view, and see the various topic’s interdependencies.
- Financial Modeling Standards
- Financial modeling foundation: Strategic scenario planning
- Life Cycle Costing
- How to write good (and simple) formulas
Applications of Financial Modeling
We can find applications of the principles of financial modeling in different areas. Most of the time, we hear the term financial modeling in the investment banking world.
In investment banking, it is used to predict a company’s potential financial performance in the future by making relevant assumptions about how the company or a specific project is expected to perform in the coming years.
For example, how much cash flow a project is expected to generate for a company within a company five years after its launch.
But Financial Modeling is not limited to investment banking anymore. It plays a crucial role for Startups, SME`s, and big corporations to plan future development and convince potential investors.
Here is a list of areas that might benefit from financial modeling:
- Investment planning and financial feasibility studies
- Economic efficiency calculation
- Risk Management
- Corporate planning, budgeting, and forecasting
- Company valuation
- Lifecycle cost analysis
- Strategic scenario planning
- Project financing and financial planning in companies
As you can see, financial modeling can be quite useful for different areas.
It seems like it’s not a bad idea to get the essentials right, right?
In the beginning, it is essential to determine what the predictive model will be used for. This directly correlates with the granularity.
The more detailed a model needs to be, the greater are the chances of errors and failed assumptions.
The other primary determinant for how to structure a model is its required flexibility.
A financial model’s flexibility stems from how often it will be used, by how many users, and for how many different uses. A model designed for a specific transaction or a particular company requires far less flexibility than one designed for heavy reuse (often called a template).
Besides, the following questions are essential:
- What is the goal of financial modeling?
- What does the financial model have to achieve?
- How will it be used, and by whom?
- What time, personnel, financial resources, etc., are available?
“Give me six hours to chop down a tree, and I will spend the first four sharpening the axe.” Abraham Lincoln
Furthermore, to achieve a great financial model is to choose the right tool and set a specific goal. The go-to tool for planning is still MS Excel, used by investment banks and big companies for financial modeling. Color coding for cells, Column consistency (uniform time axis), and Line consistency (one formula per line) need to be implemented from the beginning to avoid time-consuming reworking.
2. Financial Modeling Standards
The effort you put into financial modeling is fruitful only if it can be easily used and understood by others. Color coding, font size, trim, promotional booking names, etc., are all included in the presentation. This may sound very simple, but the combined effects of all these factors make a huge difference in the model’s appearance.
Which colors are used in financial modeling?
The most commonly used colors for financial modeling are blue for every constant used in the model. Black is used for all formulas, while green is used for cross-references from different sheets.
Logical integrity is of utmost importance. Since the author of the model may change, the structure should be strict, and integrity should be paramount. The financial model should be based on formulas that can be easily understood by other financial modelers and non-modelers. It should be flexible in scope and adaptable in any situation (as contingency is a natural part of any business or industry).
A financial model’s flexibility depends on how easy it is to change the model whenever and wherever this would be necessary.
3. Financial modeling foundation: Strategic scenario planning
Within the framework of strategic corporate planning, various scenarios are usually developed and played through. Each scenario, each path opens up different opportunities and risks. The mapping of the other options requires extended financial modeling. The tricky part is estimating figures, followed by financial modeling combined with simulations and evaluation of the possibilities.
Hint: To gauge numbers most accurate, historical data obtained offers and competitor analysis should be considered.
A simple example would be the estimation of the expected revenue for a fitness application. There are several methods available, but the most common are Top-Down and Bottom-Up.
What is Top-down financial modeling?
A Top-down revenue estimate is based on looking at the total market size and estimating the market share your company can achieve.
For example, our market research might show that our target city people spent $100 million in the fitness and supplements industry. So if we can achieve a 5% market share, we can expect to make about $5,000,000 a year.
What are the advantages of the top-down method?
The top-down method’s advantages are that it is quick and easy if you have the right data to get a good overview of the total opportunity size.
One good source of this kind of information is usually Statista.
The disadvantages are that it is not very accurate and can lead to over-optimistic estimates. The “market size” number can often be challenging to find and may be based on assumptions and forecasts from a market research firm. If your foundation is wrong, assumptions and estimates for the target “market share” will not be accurate.
For example, if you launch a new fitness application, you might see a total market size of $43 billion. Even if you only use 0.1 percent of the market, you’ll make $43 million. It sounds pretty reasonable – after all, how hard can it be to get just a tiny 0.1% market share? Much harder than it sounds, otherwise, we’d all be millionaires.
What is bottom-up financial modeling?
In the bottom-up approach, you build your estimates for your financial model from the smallest units.
This approach’s advantage is that it forces you to think about exactly how your business will make money and your expenses. It’s still not accurate because you’re still making estimates about the future due to limited information, but your estimates are based on facts.
The downside is that it can be very time-consuming to build a detailed financial model this way. You’re not just doing one calculation now – you’re adding up many different lines of income and expenses.
We add up all the different costs in our business for our fitness application and estimate them month by month into the future. Then we’ll think about how many subscriptions we can realistically sell and at what price and use that to build our sales estimate.
Financial modeling is both simple and complex. If you look at the overall approach, you will see that it is complicated, but generally consists of smaller and simple modules. The key here is to prepare each smaller module and connect them to prepare the final financial model.
4. Life Cycle Costing
Life cycle costing is a procedure to evaluate investment alternatives considering an asset’s total cost over its lifetime. The most common mistake we see within our client’s financial modeling
is that too much attention is paid to the initial capital expenditure and too little to future usage and maintenance costs. Which makes sense. It is, as a fact, quite challenging to compare the purchase and leasing of the alternative.
Solution: The principles of financial modeling allows you to determine the cash flows over the entire life of an asset. The most reliable way to compare costs between alternative solutions is to estimate all costs (payouts) over the whole life cycle and then discount the alternatives’ cash flows.
A key objective of life cycle costing is to influence subsequent and recurring costs.
This happens primarily by identifying and evaluating trade-offs between initial and subsequent costs. Thus, higher initial costs may justify lower following costs. For example, manufacturing costs increase for the use of environmentally friendly materials, but disposal costs may decrease many times over in the end). In this regard, there is a particular need to record in detail all costs associated with the startup.
Let’s have another look at our beloved fitness application.
A variety of costs influence the life cycle costs of the App beyond the initial development costs. These include but are not limited to:
- Functional Services (e.g., Push Notifications)
- Administrative Services (updates, management of users)
- Infrastructure services (servers, CDN)
- IT support (updates, bug fixes, etc.)
As you can see in the following chart, lower costs over the lifetime substitute the initial higher development costs of green.
5. How to write good (and simple) formulas
There is a temptation when working in Excel to create complicated formulas.
While it may feel good to craft a super complicated procedure, the obvious disadvantage is that no one will understand it. Probably even you as an author might have difficulties understanding it after a while.
The keep it simple stupid approach, also called KISS, even applies to financial modeling. Nobody likes unnecessarily complicated stuff. A clear structure with transparency is critical. Our Advice: To achieve simplicity, you can often break down the detailed procedure into multiple cells and simplify it.
Remember, Microsoft doesn’t charge you extra for using more cells! So take advantage of that.
Common traps in financial modeling
One of the essential formulas for the principles of financial modeling is the calculation of cash flow. The definitions show that cash flow can be used to make a statement about the company’s earnings and financial strengths. This is of great importance above all for lenders and potential investors, and shareholders.
To make this statement, all items that have no monetary value must be removed from the net income/loss for the year, as they flow into or out of the amount without any actual economic value having been received or spent. These include, for example, depreciation and accruals.
Two primary ways can be used for cash flow calculations: Direct and indirect cash flow calculation. Indirect is commonly used for all major companies.
Indirect cash flow calculation
To determine the (gross) cash flow indirectly, the items that are not cash-effective are eliminated from the year’s net income. The basic scheme for the indirect and more frequently used calculation of cash flow is as follows:
– non-cash income + non-cash expenses = Cash flow in the narrow sense.
Non-cash expenses can include:
- Allocations to reserves
- Increase in profit carried forward.
- Increase in special reserves
- Increase in accruals
- Decrease in finished goods and work in progress
- Expenses relating to other periods and extraordinary expenses
Non-cash income includes, among others:
- Withdrawal from reserves
- Reduction in profit carried forward.
- Reversal of valuation allowances
- Reduction of unique items with an equity portion
- Reversal of accruals
- Increase in inventories of finished goods and work in progress
- Own work capitalized
- Income relating to other periods and extraordinary income
If you’re wondering how the indirect method to calculate cash flow could look more practical, here’s a simple visual example for you:
The principles of financial modeling are indispensable for preparing integrated corporate planning (future-oriented) to obtain a transparent picture of a company. With good planning and structuring, even beginners can model various scenarios and the risks involved.
To convince potential investors, accurate numbers and logical assumptions are fundamental. Your financial model has to be easy to understand and neatly arranged. Most importantly, it has to display your business case convincingly.
That’s precisely where you might need to consult with an expert. Feel welcome to contact us for a free call. We will find the best way to support you and your company.