Welcome to part two of Tandem Innovation Group’s first blog series: Startup Financial Management 101! In this four part series, we will be providing the basics on managing your startup’s finances. From breaking down key concepts, to providing tips, and illustrating through examples; this series is the go-to resource for entrepreneurs. Curated with the expertise of Tandem network professionals, we want to make it simple for you to understand your startup’s finances.
Today we are deep diving into financial modelling. We will be explaining what it is, why it is important, and how you can execute it.
What is financial modelling? Financial Modeling is a forecast of a company’s financial performance built in a spreadsheet to analyze the impact of future events and business decisions.
A financial model tells us how we are going to make money and what it is going to take to make that money. It will show your assumptions on profit margin, timing of transactions with your customers and vendors, and ultimately allow you and others to have a real time framework for testing or observing your assumptions against actual operating activities. It also provides benchmarks to compare against industry players.
Why create financial models? There are three main uses of financial models in your startup:
- To run your business
- To pitch to investors
- To report to shareholders and stakeholders
Financial models serve multiple purposes when it comes to running your business. Here are a few ways these models can support your startup’s growth:
- Models that detail cash flow management will ensure your company has the cash it needs to survive (hyperlink previous post).
- Business model analysis will ensure pricing, cost, and production decisions result in profit (link last post w/profit vs. performance)
- An expected performance model can be compared to actual performance and budget to evaluate past decisions
- Comparing difference scenarios and outcomes, calculating a project’s capital requirements, and evaluating project impacts are key steps in strategic planning and decision making
- Breaking down key metrics to effectively allocate resources
Financial models are not just internal business tools, but are also essential in the capital raising process. The bigger your startup gets, and the more money you raise, the more sophisticated financial information will be required when pitching to investors. Your company’s story is important, but it must be supported by numbers that demonstrate the value created. Effective financial models will tell a story with numbers.
Shareholders are entitled to regular reporting on the business in the form of financial models. Sharing these models will build trust and credibility between shareholders and your team. They will also open up the floor for feedback, help with decisions, and encourage participation in later investment rounds.
How often should you forecast? Your startup’s forecast time frame depends on (a) the stage of your business and (b) the type of business and (c) how much cash your startup has.
At a minimum, you should have monthly forecasts. These forecasts should extend about a year for an early stage startup. If you have longer projects of engagements, forecasts might predict further than a year. If you’re an early stage business with little cash, weekly forecasts may be a better fit. Larger established businesses will have at least the next 5 years forecasted. Always have an 18 month forecast available to you so you can see what’s coming in the horizon and have enough time to deal with potential cash shortfalls from assumptions that may not prove to be as originally planned.
At the end of each forecasted period, make sure you review and update your plans moving forward given past results.
Wondering what financial statements really are? There are actually three financial statements components:
- Balance Sheet
- Profit & Loss Statement
- Cash Flow Statement
The balance sheet records all your assets and liabilities as of a certain date. Total assets always equals total liabilities plus shareholders’ equity. This financial statement will determine whether or not the company’s assets will meet its obligations. It shows how your business is financed and where it has invested its money.
The profit & loss statement shows all revenues, costs, and expenses incurred during a specified time period. A cash flow statement shows the cash entering and leaving a business. Note that there is a difference between a cash flow statement and a cash flow forecast. Make sure to check out our blog post on Cash Flow to learn more.
What is sales forecasting? Sales forecasting involves predicting sales for a specified time period. This could be a prediction for the company as a whole, or for a team or individual. There is no cookie cutter way to forecast your startup’s sales. Understanding what drives your business and the resources you have available will help you strategize your sales forecasting.
The two sales forecasting strategies are the top-down method, and the bottom-up method.
Top-down sales forecasting starts with the market (global market, target market, etc.). It looks at how much you can capture of the total market, or of a specific segment of customers.
Bottom-up sales forecasting starts with your business. There are four key factors to consider when forecasting sales using the bottom-up method;
1. Customer Acquisition
How much money does each customer cost to acquire? How much money can you invest in marketing?
2. Churn Rate
How often do you lose customers?
What is your physical production capacity? What is your server space? How much human capital do you have?
4. Product Development
How long will it take you to build new products? What is your engineering capacity?
Trying to decide between using a top-down or bottom-up sales forecasting strategy? It is usually best to use a combination of both.. Start with bottom-up, and then sense check with top-down forecasting.
The following are key qualities to consider when using each forecasting method:
- Faster and easier
- Market forces are outside management’s control
- Tends to be overly optimistic (which can paint a good picture for investors)
- Can lack granularity and credibility
- Requires more detailed calculations and models
- More actionable as the inputs are in management’s control
- Usually more realistic (could underwhelm investors)
- Credible when supported by company data
How Can You Forecast Using Marketing & Acquisition Cost?
Historical figures for customer acquisition cost (CAC) and churn percentage can be applied to future periods to determine sales. This is typically used in businesses where the money you spend drives sales.
CAC = marketing spend / units sold
Step 1 – Figure out what drives sales
This could be marketing dollars, sales people, referrals, or any other drivers.
Step 2 – Figure out what your resources are and how efficiently they generate sales
This could be sales per marketing spend, per sales person, per customer, or any other unit.
Churn % = customers lost / beginning customers
Churn percentage is used for repeat businesses. If you only ever have one-time sales, churn will not be relevant, as every customer is a new customer and is lost after sale.
Not sure what expense forecasting is, or don’t know where to start? There are many types of expenses your startup will incur, and it is important to differentiate each one. Why? Because we need to understand the nature of the costs and what drives them in order to effectively forecast them.
Cost of Goods Sold (COGS) are all costs directly related to producing goods or providing services for sale. For a physical product, this would include cost of labour, materials, and manufacturing overhead. In the digital economy, this would include costs such as hosting costs, customer support, and engineering maintenance.
Operating expenses are often mistakenly included in the cost of goods sold, but are not the same as COGS. Operating expenses include all costs involved in running the day-to-day operations of a company, excluding COGS, and excluding finance/investment costs.
Costs can also be segmented into fixed and variable costs. Variable costs vary based on the amount of production. Fixed costs do not vary based on the amount of production. Fixed costs may increase as the company grows (for example: the rent for a larger factory will be greater than that of a smaller one)
In general, your COGS will vary with your sales. Operating expenses will vary with the size of your business.
Variable COGS are things like direct labour and materials for physical products. FIxed COGS are things like manufacturing overhead.
Variable operating expenses are rare, fixed operating expenses are where most of your company’s costs will fit. These are things like payroll, product development, marketing, rent, insurance, utilities, travel, etc.
There’s More To Come!
This is not the end of our financial management series! Our goal at Tandem is to make it easy for you to establish a sound financial platform to build your business on. Our last post looked at cash flow. Next, we will be looking at unit economics and profitability; what it is, why it is important, and how you can execute it.