After a gondola ride, whether you ski or snowboard, you’re not getting far without the right equipment.
Let’s imagine you’ve made it to the top of a snow-covered mountain. The distant view is inspiring and there are endless ways to enjoy the ride back down. Similarly, there are endless ways a business can evolve.
Financial modeling is an important technique that helps us simulate different scenarios for a business.
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This contribution was written by Jeff Erickson. Jeff is an investor, advisor, and skier on the silicon slopes of Utah.
A financial model helps forecast the financial performance of a company. They are based on the company’s historical performance and assumptions about the future. This tool can be used to make better decisions when raising financial capital and to assess potential returns of a given venture.
Returning to our mountainous metaphor, think of financial models as your map of the snowy terrain. It provides an overview of the area, routes to explore, and dangers to avoid. Like a trail map, financial models use numbers to set the scene, then help us determine the speed and direction of our business. They also help identify potential risks and optimize how different types of resources are used.
A financial model is essentially a roadmap for the future, and it gives investors an understanding of how you plan to generate revenue and scale over time. A solid financial model demonstrates that you have done research into the market, understand potential risks and opportunities, and have thought through the key drivers for success. Your financial model helps investors see how you think about your business and whether you understand the levers that matter. It also gives them confidence when they see that you know how to strategically allocate the money they may invest and that you know how to manage cash flow.
Most investors speak in the language of finance. Terms like run rate, CAC, LTV, runway, and burn rate are common vernacular. Building your financial model helps you learn, decipher, and understand this language of finance, enabling you to more effectively work with investors.
A common mistake is thinking that it’s you and your financial model versus the world. Instead of falling in love with assumptions, work with potential investors by using the financial model to analyze various scenarios. When founders can cruise down the mountain with investors while using a financial model to explain different scenarios in real-time, partners will get more excited about taking the lift back up for another run.
Entrepreneurs need to be aware of the changing terrain to make the best decisions for their evolving business. Let’s avoid the trees and carve out a few steps that will land you in a position to know the numbers.
Define
Before building a financial model, it is important to define the company’s business model, revenue streams, and financial objectives. This information will determine how you structure assumptions for the projections to accurately reflect what could realistically happen with your business.
Gather
Once you define company goals, gather historical data relevant to creating accurate projections. This includes past sales, costs for running operations, generating revenue, customer acquisition, and any other financial data that may help tell the story of your business.
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Prevent that new business idea from floating toward someday by compiling relevant resources that brew confidence in getting others excited to join you.
Build
Using qualitative (industry trends) and quantitative (past results) data points, build realistic assumptions to drive your financial model. This can be done using spreadsheets, but dedicated software makes it easier. With a framework in place, begin with customer acquisition data (sales outreach, paid ads, referrals, etc.). Next, make assumptions around revenue streams by considering all the ways you can make money (product sales, services, advertising revenue, etc.). Continue by including resources related to building a team, then focus on any changes in operating expenses. Finally, consider any required expenses to scale your business and how to finance the venture long term.
Validate
Once initial assumptions are plugged into a financial model, it’s important to track the accuracy of your assumptions each month and to update the numbers based on actual data. With metrics consistently tracked over time, your financial model becomes more accurate and reliable. You will notice trends in customer acquisition, identify the most profitable revenue streams, and monitor your expense projections. Additionally, you will be able to run different scenarios using your financial model to help you confidently make better decisions in running your business.
As we add financial models into an investor pack, dynamic understanding is supported by an interactive tool to project progress. This shared awareness brews confidence and helps more people enjoy the ride in a shared direction.
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#9 📖 Entrepreneurship
