What is a financial model?
While they are often prepared by finance professionals, a financial model is simply a tool you use to help you achieve a goal so ‘what it is’ depends on what goal you are trying to achieve.
At its heart, a financial model is the translation of actual and projected operations in to numbers so that you can understand and project the financial implications of whatever you are trying to achieve. Financial models are invaluable tools in a number of scenarios including:
Raising funds - helping you translate your future plans in to financials so you can understand how much money you need to raise and be able to articulate to potential funders how their money will be invested and how they can achieve a return on their investment
Making business decision - a financial model allows you to evaluate the implications of a decision from confirming how much something will cost to evaluating the impact of price changes or investing in a new product line
Developing budgets & forecasts - the periodic process through which operational plans are optimised and translated to financials thereby setting out how much is expected to be spent on what and why, and how this relates to the income that the business expects to generate - this is a critical element of financial governance and empowering people in the organisation to make decisions
Knowing how long your cash will last - no cash = no business so particularly in early stage businesses, understanding cash runway ensures that you can be on the front foot both in terms of most impactful investment of your limited funds and being in control of when and how you raise funds
Understanding your business - analytical reviews such as product/service profitability or a cost base deep dive enable you to make informed changes to achieve improvements in your commercials
Okay, so there are a number of different reasons that one might use a financial but what do different types of financial model look like? There are some key elements of a financial model that change depending on what you are trying to achieve:
Single use vs ongoing - some financial models will be used to make a decision at a point in time and then their job is done. Others, will become the financial reference point for a period of time or be updated with actuals or new assumptions. Ongoing models tend to be more complex and take longer to build because
Who it is for - different audiences will prefer, or may even require certain elements from a financial model. Professional investors such as VCs for example typically require an Excel based 3 statement model, while an internal foreacast may use an FP&A tool that integrates with your accounting system and an internal business case may be a simple Google Sheet
Whether it includes actual data - budgets and investment models typically require 1 to 5 years of actual data both to help project the future and assess metrics such as year on year growth. The structure of the model will either need to align with the existing data or a schedule will be required to translate the historic data in to the format for the model. This can become even more complex if multiple different historic datasets are brought in to the model (e.g. multiple entities, data from multiple systems, financial and non financial data).
Variables & scenarios - the higher the number of variables that you want to be able to change the more complex a model becomes, especially if the variables are related to each other. Some financial models benefit from going a step further and modelling ‘scenarios’ where groups of variables change (e.g. best case, expected and worst case).
Regardless of the type of financial model and its purpose, there are 3 critical elements:
Inputs - key variables that you want to be able to adjust. These may be variables that you control (e.g. price, volume, date that something is effective from), or external factors that significantly impact what you are modelling (e.g. inflation, supplier price increases, minimum wages increases, seasonality)
Workings - the detailed mechanics of the financial model process the inputs and turn them in to the relevant financial schedules (e.g. P&L, balance sheet, cashflow forecast, payroll workings, product level income and costs)
Outputs - a high level summary of what the financial model is saying that is easy to understand, often includes visualisations as well as tables and clearly answers the question that is being asked of the model
Whatever you are trying to achieve with your financial model, having a clear articulation of the business need before you start will help you identify what sort of financial model you need, the data you will require and an idea of how simple of complex it will need to be.
