If you are a person who dislikes numbers, think twice, knowing how to build a financial model is essential. When creating a business model, financial planning and the construction of a strong and well thought financial model become necessary for the development of a successful company, as well as to generate financial value and return for its investors.
A financial model is generally used for three main reasons:
a) Financing: investors make a financial forecast in order to value a company or project and finally decide whether to invest in it or not.
b) Strategy: the financial model is a reflection of the business model, revenue model and the main strategies of the company translated into numbers.
c) Management: a financial model can be of great help to the management team when projecting growth and setting milestones, as well as adjusting the business growth strategy. It acts as the benchmark that you can review against the actual results on a monthly, quarterly or annual basis.
3 Financial Statements Model
The three elementary financial statements are the Income Statement (P&L), the Balance Sheet (BS) and the Cash Flow Statement (CFS).
-The Income Statement describes the performance of the company over a period of time, it can be a month, quarter, year, etc.
-The Balance Sheet is a snapshot of the company at an specific moment in time. On one hand, it describes the assets such as the cash position and what the company owns; and on the other hand it describes the way the company finances those assets through liabilities (what the company doesn’t own and/or borrows) or equity.
-The Cash Flow Statement indicates liquidity and the inflows and outflows of cash through operating (working capital), investment (capex) and financing activities (debt or capital).
Step 1. Project the Income Statement
The easiest way is to calculate the historical growth of income and project it with a compound annual growth rate (CAGR) for the following years adjusted by the growth expectations.
It is best to create an income projection like the one shown below considering your business model and the key elements that determine the industry you are in. For example, in sectors such as retail technology the key is volume multiplied by a price. In other productive sectors, the production capacity dictates income through the capacity of use by volume. The telecommunications sector depends on the income generated by each user and the retention rate. Other revenue models include commissions, membership-like fees or royalties, among other.
b) Cost of Goods Sold (COGS), Operating Expense (Opex), EBITDA
The easiest way to project these items is to calculate the historical margin (% of sales) of the last periods and apply it in the projections adjusted to the growth expectation and operational improvements.
The optimum is to build each of the components from the base. For example, the current personnel cost and projecting it according to the growth of personnel in the company, the cost of the raw material for the manufacturing of a product, etc. Another option is to consider profitability metrics such as the generation of EBITDA in proportion to some metric, for example, EBITDA by volume, among others.
c) Depreciation and amortization (D&A), Interest Expense and Taxes
- D&A: to project depreciation and amortization it is recommended to consider it as a percentage of sales, although the most precise method should be by creating a depreciation schedule.
-Financial interest expense: it is calculated be taking the debt balance of the Balance Sheet and using the real interest. In such cases where different types of debt exist, the financial interest should be calculated for each of them.
- Taxes: they are calculated using the rate established by the jurisdiction where the company is based.
Step 2. Project the Balance Sheet
-Cash: it is the last line that is projected after having built the Cash Flow Statement (Initial Cash + Change of Cash = Final Cash)
-Operating assets: they are part of the working capital, and they include:
— Accounts receivable: These are credit sales that are pending to collect. The way to project them is through the number of days it takes the company to collect them [Days Sales Outstanding (DSO) = (Average Accounts Receivables / Sales) * 365].
— Inventories: it is the economic amount of the product (in process or final) that the company holds. It is also calculated considering inventory turnover in number of days [Days of Sales in Inventory (DSI) = (Average Inventory / COGS) * 365].
-Fixed assets: includes property, plant and equipment (PP&E). The balance of the account depends on accumulated depreciation and capital spending. (Gross PP&E + Capex + Accumulated D&A = Net PP&E).
-Capital expenditure (CAPEX): It is the capital investment for the company to achieve its production or growth objectives. The Capex can be for maintenance or for expansion purposes. Its projection is linked to the company’s growth plans.
Financing coming from third parties that the company receives through different sources to support its assets.
-Operating liabilities: they are part of the working capital, and include:
— Accounts payable: These are pending payments to suppliers. The way to project them is through the number of days it takes the company to pay them back [Days Payable Outstanding (DPO) = (Average Accounts Payable / COGS) * 365]
-Financial debts: Liabilities that have a financial cost. The projection is made considering a repayment schedule.
It is the contribution of the shareholders and the cash flows that correspond to them, with which they finance the operations of the company.
-Paid in Capital: Those are the contributions of the shareholders. This can be projected by considering future capital increases that come from the shareholders
-Retained earnings: they come from the net profit of the business operations. The portion that is not distributed as a dividend to shareholders is retained to support the expansion of the company.
Step 3. Project the Cash Flow Statement
The Cash Flow Statement is constructed with the Income Statement and the Balance Sheet accounts. This includes the Cash Flow from Operation (Working Capital), the Cash Flow from Investments (Capex) and the Cash Flow from Financing (which comes from liabilities and / or capital).
The result of those accounts is the change in cash and therefore the result of the final cash balance.
-Try to make a financial model of 10 years or at least 5 years.
-Build first the Income Statements, then the Balance Sheet and finally the Cash Flow Statement.
-In the Balance Sheet always check that the assets are equal to the sum of the liabilities and capital.
-Use reasonable and justified assumptions when projecting each account.
-Validate that the financial margins of the business, the growth rates, the liquidity and the cash balance make sense with the business model and with your marketing documents, such as your investors’ presentation. In general, check that the numbers really make sense.
-The Balance Sheet, the Income Statement and the Cash Flow Statement are interrelated. A good financial model has circularity. When structuring it, use a switch button (toogle) in the financial interest expense line, in the Income Statement and in the cash line of the Balance Sheet. In this way there will be two scenarios, one where circularity is broken and another where it remains.
-Strengthen your analysis by creating a base, a downside and an upside case scenario.
A good financial model is the result of strategic business planning, it leads entrepreneurs to get to know their business model and strategy much better. In addition, it is the mean to financially communicate the plan to investors. Work hard on it and use it daily to guide the company. If there are differences between the current financials and the projected results, learn from it so that you can improve every day.
Hector Shibata. Director of Investments & Portfolio at ACV a global Corporate Venture Capital (CVC) fund.
ACV is an international Corporate Venture Capital (CVC) fund investing globally in Startups & VC funds.
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