What is Financial Modeling for Startups?

Two Approaches to Startup Financial Modeling

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#1 – Top-Down Approach

In the top-down approach, the entrepreneur starts with macro factors and then works through the micro factors. Starting points are the industry standards, which narrow down to targets the companies can fit in. This approach helps define the forecast based on the market shareMarket ShareMarket share determines the company’s contribution in percentage to the total revenue generated within an industry or market in a certain period. It depicts the company’s market position when compared to that of its competitors.read more you want to acquire.

TAM (Total Available Market), SAM (Serviceable Available Market), and SOM (Serviceable Obtainable Market) models help in this kind of approach. In this model, at first, TAM for the product is estimated. Then we have to decide the part of the market we want to acquire, known as SAM. From that SAM, the existing service base of the company is known as SOM based on the existing competition. So in this model, we start with industry size to the market share we can capture.

#2 – Bottom Down Approach

The main problem with a top-down approach is that it can be too optimistic. Usually, we take SOM as a percentage of the total market, which is very hard to achieve. In the bottom-down approach, the entrepreneur takes a tiny portion of the market for his sales and then assesses the sales from his company’s inside point of view to estimate the forecasts and modeling procedures.

Steps to Create a Startup Financial Model

Here we use the top-down approach to create the financial model in excelCreate The Financial Model In ExcelFinancial modeling in Excel refers to a tool used for preparing the expected financial statements predicting the company’s financial performance in a future period using the assumptions and historical performance information.read more

  • Revenue: The first thing is to determine and forecast the revenue for the product you are launching. It can be a bit tricky because you are a new entrant into the market. For determining the sales, you can use the Total Available Market (TAM), Serviceable Available Market (SAM), and Serviceable Available Market (SOM) model. First, the total available market is to be determined and from that company’s estimated revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more needs to be found.Costs: This can be easier since the firm controls its resource and overhead costs. Costs will include direct costsDirect CostsDirect cost refers to the cost of operating core business activity—production costs, raw material cost, and wages paid to factory staff. Such costs can be determined by identifying the expenditure on cost objects.read more, overhead costsOverhead CostsOverhead cost are those cost that is not related directly on the production activity and are therefore considered as indirect costs that have to be paid even if there is no production. Examples include rent payable, utilities payable, insurance payable, salaries payable to office staff, office supplies, etc.read more etc.Income – To achieve and calculate Operating IncomeOperating IncomeOperating Income, also known as EBIT or Recurring Profit, is an important yardstick of profit measurement and reflects the operating performance of the business. It doesn’t take into consideration non-operating gains or losses suffered by businesses, the impact of financial leverage, and tax factors. It is calculated as the difference between Gross Profit and Operating Expenses of the business.read more and Net IncomeNet IncomeNet Income formula is calculated by deducting direct and indirect expenses from the total revenue of a business.. It is the most important number for the Company, analysts, investors, and shareholders of the Company as it measures the profit earned by the Company over a period of time.read more, we use the above two parameters. You can calculate Operating income by subtracting operating costs from revenue.Growth Rate – The future growth rateGrowth RateThe Growth rate formula is used to calculate the annual growth of the company for a particular period. It is computed by subtracting the prior value from the current value and dividing the result by the prior value.read more for revenue and costs also needs to be determined, which can be quite tricky, given the uncertainties over the future. For projecting future revenue, the industry outlook, the company’s available cash, and future investment need to be seen. Cost projection can be a function of revenue.

Below is the excel format for the Startup financial model:

Assumptions Used in the Model

  • Base Revenue or market share is one of the main assumptions for startups. Usually, entrepreneurs try to drive it through the industry standard and their positioning.The growth rate is one of the main assumptions driving the financial model. While taking the revenue and cost growth rate, the entrepreneur needs to understand the macroeconomic factorsMacroeconomic FactorsMacroeconomic factors are those that have a broad impact on the national economy, such as population, income, unemployment, investments, savings, and the rate of inflation, and are monitored by highly professional teams governed by the government or other economists.read more such as industry or country health, and then look through their startup’s cash position.Future investment: For growth, startups need continuous investment from external sources, and they will also have to make that assumption while creating the financial model.

Why should an Entrepreneur Focus on Financial Model?

While creating the financial model, the entrepreneur can understand some aspects of the business that he otherwise won’t be able to understand. Though there are many templates for financial modeling present online, entrepreneurs should always create the model, keeping in mind the nature and assumptions of their business.

Also, by working through each row and column of the financial model, the entrepreneur can understand what the missing aspects of the business are; or what elements are unnecessary and remove those from the financial model. It also boosts their confidence while presenting to the investors.

Why Build Financial Model for Startups?

  • It helps in understanding the revenue and cash flow forecastCash Flow ForecastCash flow forecasting is forecasting or anticipating the cash inflow and outflow for the future period by the management of the business to make sure that the business will have sufficient funds to carry out the activities on a regular basis, and if there is any shortfall, they has to plan for alternate sources of funding for the business.
  • read more for the business.It helps in understanding the company’s assumptions while creating the business.Investors carefully look through the financial model before investing in the businessIt helps in understanding the viability and profitability of the businessProfitability Of The BusinessProfitability refers to a company’s ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company’s performance.read more.It helps in presenting the real picture of the business to the external investor and debating the investment terms.It helps in quantifying the assumptions for the startups.

This article has been a guide to Financial Modeling for Startups. Here we discuss the approaches to creating the model along with a step-by-step example.  You can learn more about it from the following articles –

  • Financial Modeling CourseFinancial Modeling ConsultantFinancial Modeling ProcessFinancial Modeling Benefits