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What is a financial model?
A financial model is a document designed in Microsoft Excel, Google Sheets, or similar software that contains inputted data from your business, a set of formulas and assumptions that process the data, and an output section that displays results. You can design it from scratch using our plain financial model template or opt for SaaS- or e-commerce-tailored options for a faster buildup.
What You’ll Learn in This Article
We assume you’re reading about financial models because you want to know how they can help your business and how to build and use them. So, our discussion will be as actionable as possible, focusing on the practical aspects of financial modeling.
Financial modeling, at its core, is a tool used to analyze a company's financial performance and projections. We’ll describe what a financial model is as briefly as possible to give you a quick understanding of the concept so you don’t face any challenges studying it in-depth. You’ll also learn about the sections of a financial model, its uses, types, and how to master the skill of using or designing one. In addition, we’ll describe a few financial model examples to practicalize the discussion.
Why Every Business Should Use Financial Modeling
A financial model is essential for any business owner or top employee in a startup. Making big decisions about your business without using a financial model is risky because you don’t know the future impact of today’s decisions. It can help you avoid deal-breaker mistakes in your startup pitch deck stock offers.
Not using a financial model in your business means you only make decisions about the future based on assumptions. Sometimes you may be lucky, and any negative impact from that decision won’t shut down your business or push you down to the lowest rungs on the competition ladder.
So, what exactly do businesses use a financial model template for?
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Let’s find out below.
5 Uses of Financial Modeling for Startups
There are many uses for a financial model.
Here are five benefits of financial modeling to give you a more solid understanding of what it is and what it’s for:
- Mitigating risks
- Raising investment capital
- Foreseeing future opportunities
- Forecasting future costs
- Pricing new products or services
Mitigating Risks
Every business faces future risks from unexpected changes in market forces or wrong management decisions. There's no point when your business isn't facing one or more threats to its profitability. You have to try and identify the risks in good time and manage them well to neutralize or weaken their impact.
Financial modeling plays a crucial role in this process. Your business can face risks from prices, marketing, competitors, etc. Our financial model template is designed to help you discover and manage future risks properly, enabling you to make informed decisions and safeguard your financial stability.
Raising Investment Capital
Investors want you to convince them that your startup is or will be profitable — there's no better way to do this than with a financial model. Even if you would be easygoing about financial models, you’ll need to up your game when it comes to the model for fundraising; your fundraising model must be investor-grade if you want to be taken seriously.
Such a model has several components, including financial modeling, that make it as realistic as possible, and our financial model template contains all the necessary components and can even accommodate more. Financial modeling plays a pivotal role in projecting your startup's financial performance and viability for potential investors.
Foreseeing Future Opportunities
Financial models can provide a glimpse of opportunities ahead, enabling you to take advantage of that knowledge to make more money or avert loss. For example, after processing business data for the past two or three years, entrepreneurs may identify an upward or downward trend that reasonably estimates their future market sizes.
This will prompt a reduction or scale-up in production to minimize losses or maximize profits through effective financial modeling.
Forecasting Future Costs
Another way businesses use financial models is to estimate future costs.
For example, you want to hire more talent for your business; this means you’ll spend more on salaries. A financial model can visualize the impact of this new change on your overall income. This is a very common financial model example due to the importance of the information it provides.
This information may induce you to postpone hiring, reduce or increase the number of staff, or proceed with your original plan. After processing past and present data on your revenue and costs, you may discover that you currently can’t afford new staff, particularly if your profit graph is trending downwards.
Pricing New Products or Services
Let’s assume you’ve conducted market research and obtained data on the market size of a particular product or service you want to offer. You may want to use your present company’s facilities, additional talent, and other resources to develop this product or service.
Financial modeling can reasonably estimate any future profit or losses from that software at specific price points. You can increase or reduce your prices according to the results of your financial model, making it a crucial tool when rolling out a new product or service in this financial model example.
Parts of a Financial Model
We already mentioned the various sections of a financial model, but we want to describe them further here to paint a bigger picture of their features.
In summary, here are the three parts of a financial model:
- The input section
- The processing section
- The output segment
The Input Section
The input section is designed to accommodate all data critical for the model. It’s usually highlighted in yellow or uses a blue font to differentiate it from the other two. The first thing you’ll see after the title of a financial model is the input segment.
The Processing Section
This is where your formulas and assumptions operate. It typically contains a handful of formulas inputted in the same or different cells. This section is usually protected from unauthorized changes because a slight change in any formula can invalidate the results. Circular reference errors may also occur with similar effects.
The Output Segment
Your formulas need a place to display results. Before investors and lenders start spending time on your model, they’ll first scrutinize the output or results.
Financial modeling involves creating these results through calculations based on inputs. Depending on what they see, they can decide to study your model further. You want to present this information to them plainly. This is why most financial models use pictorial representation, like charts and graphs, for the results.
Learning Financial Modeling Skills
We’ve seen the benefits of financial modeling.
So, how do you learn to design a financial model?
First, you must understand what a financial model is. We hope our explanation has given you a basic understanding of a financial model, its uses, and its essential components. Next, let’s outline some advice on how to go about learning financial modeling skills.
Learn how to use at least one software capable of creating models. You must also understand the formulas and assumptions required to calculate specific values from your raw data. For example, to calculate the churn rate, you need to divide lost customers by total customers within a set time frame and multiply the result by 100. Many such formulas are required for some financial models and can be more complex, mainly when several driving factors exist.
Frequently Asked Questions
What do you mean by financial model?
A financial model is a spreadsheet that forecasts your business’ future performance by analyzing past and present data through formulas and assumptions.
What are the six types of financial models?
While there are many types of financial models, here are the major six:
- Three-statement model
- Credit rating model
- Leveraged buyout model
- Discounted cash flow model
- Merger model
- Comparable analysis model
What is a financial model and its advantages?Â
A financial model is a document that uses a company’s past data/performance and assumptions to provide insights into the company’s future financial performance.
Here are four advantages of a financial model:
- Help convince investors and money lenders to fund your business
- Help you avoid losses by offering a glimpse of the future
- Essential for acquisitions and mergers
- For pricing new products and services
How do you make a financial model from scratch?
There are seven steps to creating a useful financial model:
- Gather historical data.
- Build a three-statement model.
- Decide what to forecast.
- Identify all critical input factors.
- Define the users.
- Plan the model.
- Use test data to validate the model.
However, we recommend using a financial model template, as building one from scratch is a complicated process prone to errors.
What should a financial model look like?Â
A financial model should provide enough detail for decision-making and be easy to read and audit. Its content should include information on assumptions, discounted cash flow analysis, an income statement, a balance sheet, a cash flow statement, and sensitivity analysis, all of which are essential components of financial modeling.
Supporting schedules and additional information that backs up the model's conclusions should also be included. Outputs should feature charts and graphs instead of numbers only, and the model can use different colors to identify its various sections, enhancing its clarity and usability.
Conclusion
We’ve discussed in considerable detail what a financial model is, its uses, components, types, and how to acquire the skills to use and design one. This article doesn’t contain everything there is to know about financial models, but there’s enough to give you a foothold for further studies. For more information, you could check out our post on creating a financial model for a startup.
It’s okay if you don’t intend on personally designing your business’ financial models: in fact, we don’t recommend it as it’s a complicated procedure that’s open to errors. To simplify your startup journey, we provide a wide range of business services, which include a financial model template. Our help is always within reach for any financial models you want to build — contact us for a free consultation or any inquiries you might have.
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