Importance Of Financial Modelling For Startups & Small Businesses
Money management is a skill that most entrepreneurs need to have to make their startup successful.
But as some entrepreneurs focus on other aspects of their startup, they found themselves out of money after just a short period.
As the business grows, the flow of money becomes hard to manage. And when a startup has to deal with investors’ money, keeping up with the finances becomes hard.
So, for a startup to have sustainable growth, it should know and record where the money is coming from, where is it going, how well is the financial performance, and how it will perform financially in the coming months, for it to have sustainable growth.
Financial Modelling makes it easier for startups to understand their finances easily and managing money well.
What Is Financial Modelling?
It is the process of creating a summary of a company’s expenses, and earnings in the form of a spreadsheet that can be used to forecast a business’ financial performance into the future.
The calculations performed in Financial Modelling are based on the company’s historical performance and assumptions about the future.
Financial Modelling requires preparing an income statement, cash flow statement, balance sheet, and supporting schedules (known as a 3 statement model).
By preparing these, more advanced types of models can be built. These models include the discounted cash flow model (DCF model), leveraged-buyout (LBO), mergers and acquisitions (M&A), and sensitivity analysis.[Read: Top 9 Active Venture Capital Firms in India]
Uses Of Financial Model
A financial model is used for decision making and performing financial analysis.
In a company, executives will use financial models to make decisions about:
- For fundraising (debt, and/or equity)
- Budgeting and forecasting
- Deducting the value of a business
- Priority-based capital allocation
- Financial ratios and statement analysis
- Management accounting
- For Acquisitions (businesses and/or assets)
- Growing the business organically (e.g., opening new stores, entering new markets, etc.)
- Selling or divesting assets and business units
Importance of Financial Modelling For Startups
- It helps in quantifying and validating your business plan and business model. Preparing a financial model helps in finding out whether you can turn your ideas into a sustainably operating business.
- During the fundraising process, investors will generally ask you for a financial plan. As every investor follows a different approach, certain investors will require more details than others. But as a financial model provides quantifiable data, a startup should always prepare one.
- Financial Modelling also becomes important for a startup as it presents the exact financial situation of the startup. It also helps in providing the investors with a real-time financial situation and shows them how you are spending their money.
Types of Financial Models
Financial Modelling is a very intricate process, and one should always consult a financial modelling professional.
There are multiple different types of financial models. In this article, we will show you the top 5 most common models used in corporate finance and are relevant to startups.
1. Three Statement Model
The ‘Three Statement’ in this model stands for income statement, balance sheet, and cash flow statement.
This is the most basic setup for financial modelling, and it links the three statements-income statement, balance sheet, and cash flow statement into one dynamically connected financial model.
It is used as the base of complex financial models like discounted cash flow, merger model and other financial models.
2. Budget Model
Budget Model focus heavily on the income statement and is used to prepare the budget together for the coming year(s).
This type of model is typically designed to be based on monthly or quarterly figures.
3. Forecasting Model
As the name suggests, the forecasting model is used to predict outcomes regarding supply and demand, sales, consumer behaviour and more.
The model is to generate a forecast that compares to the budget model. And depending on the output, budget and forecast models act as one combined workbook, and sometimes they are separately used.
4. Discounted Cash Flow Model (DCF)
It is the method of analyzing the present value of an investment/company/cash flow by adjusting future cash flows to the time value of money, where this analysis assesses the present fair value of assets/investment.
The model takes into account multiple factors like inflation, risk and cost of capital, to derive the forecasted free cash flows, which are then discounted back to the present fair value.
5. Merger Model (M&A)
In this model, the financial statements of the buyer and seller in an acquisition are combined to deduce the effects of the deal. Merger Model ascertains whether or not there exist benefits to an amalgamation.
Depending on the complexity, requirements and availability of data,
it takes 30-60 minutes to prepare a simple merger model, and for complex cases, it takes multiple hours or days to complete.
Some other most commonly used financial models include Initial Public Offering (IPO) Model, Sum of the Parts Model, Leveraged Buyout (LBO) Model, Consolidation Model and Option Pricing Model.
What gets measured, gets managed. That is why Financial Modelling is important for startups as it helps them budgeting and forecasting,m raising capital, management accounting, priority-based capital allocation, etc.
Keep that in mind, Financial Modelling is a very complex process, and one should always consult a financial modelling professional.
As a front runner in the startup ecosystem, The StartupLab provides entrepreneurs and startups with all the legal and technical services. So, if you need Financial Modelling for your startup, contact The StartupLab.[Read: Requirements And Process For LLP Registration In India]