How to build a financial model

How do you build a financial model? A financial model can show what profit a company or project can earn and under what conditions. A startup's financial model is based on its business model; that is, you first need a description of the target audience, the customer acquisition processes, the features of the product, and how it is obtained. Then, based on a quantitative assessment of customers, promotion, and conversion, the company's financial performance indicators are determined. It is useful to look at the public financial statements of several companies in a similar industry, study the structure of their P&L and cash flow, determine the most suitable structure of line items and analytics for your project, and collect classified data and analyze it.

You need to set a planning horizon, that is, what period the model will cover. Usually it is one to three years. To build a financial model, you first carry out revenue calculations, analysis, and structuring of income. This is easier to do by answering these questions: Where do new customers come from? Does the company have a regular customer base? Are there sales funnels? Which sales channels does the startup use: a website, direct sales through managers, social media, and so on? Each sales funnel needs to be described in detail and its conversion forecast, ideally based on current traction.

Next, you need to build the expense block, dividing expenses into direct and indirect ones. Direct expenses are those that go directly into producing specific goods and services. The difference between revenue and direct expenses is gross profit. Indirect expenses are those that are hard to attribute directly to production. They include back-office salaries, office rent, banking services, and so on. The difference between gross profit and indirect expenses is operating profit. By subtracting interest on current loans and other expenses, as well as taxes, from operating profit, we get net profit, which in turn shows how much the company has earned and what its growth is.

Not only net profit can be used to pay dividends to the company's owners, for its development, and for building reserves. However, calculating net profit is not enough. There are situations when a company has profit but no money, and vice versa. This often happens because money comes into the company at different times, or because more is spent on purchasing what is needed than has been earned. To keep this under control, you need a forecast of cash movements, essentially CF, cash flow. You can add a sensitivity analysis to the financial model: a table of the key indicators that affect net profit more than others. For example, if you change the sales conversion by 10%, net profit will grow by 30%. If you change the average order value by 10%, net profit will increase by 50%.