How to Create a Business Financial Model
In the recent article, How to Create an Effective Pitch Deck, I discussed the importance of the pitch deck as a fundraising tool and listed what I believe are the most important pages or slides that should be included in a pitch deck. One of the most important pitch deck pages, if not the most important page, is the financials. In this article, I will discuss in more detail how to create a financial page and accompanying financial model.
The Role of the Financial Model
Not surprisingly, potential investors are going to be very interested in how your company will generate revenue and earn profits. Your financial page should include a broad overview of projected sales, expenses, revenue and profits, focusing on the big picture and bottom-line numbers.
However, you can’t go into a tremendous amount of financial detail on a single page that’s part of a pitch deck. Instead, you will flesh out the financial details in a separate financial model.
Your financial model will consist primarily of financial projections — specifically, forecasts of sales, expenses, revenue, profits and cash flow for the next one to three years. These projections are essentially educated guesses — or more accurately, very educated guesses — about your future financial performance.
Financial forecasts should be much more than just “pie in the sky” numbers, though. They should be based on solid assumptions that are in turn based on market realities. The “hockey stick” forecast is common in many financial models, showing flat sales for a period before they shoot straight up. This will certainly be appealing to investors and might even grab their attention initially. But if the numbers aren’t based on realistic assumptions, investors will see right through them as soon as they start digging into your financial model.
There are no shortcuts to creating financial forecasts based on solid assumptions. You must spend the time necessary to conduct thorough research to answer such questions as:
What is the size of our target market? In other words, approximately how many potential customers exist who are viable candidates to buy your product or service?
How many competitors are currently in the market? Is there something that sets your product or service apart from these competitors?
How much will it cost us to manufacture products or deliver services? What will be your cost of goods sold (or COGS) and how volatile will COGS be from year to year? Raw materials and inventory are the two main COGS items for manufacturing companies.
What kind of overhead will be required to run the business? Overhead includes things like employee salaries, rent or mortgage and utility bills. Overhead remains steady for most businesses, at least in the short term.
Components of the Financial Model
A business financial model should typically include the following six components:
Revenue forecast — Use a spreadsheet to project sales numbers for the next five years. Also include COGS in your sales forecast so you can calculate gross margins — investors will be especially interested in this.
Expense budget — For most businesses, expenses usually include both fixed and variable costs. Fixed costs consist mainly of overhead items like those listed above, while variable costs include things like advertising and marketing that will fluctuate based on your volume of business.
Capital expenditures — All businesses need long-lived assets, such furniture, fixtures, machinery and equipment to operate so it is important to forecast the timing, cost and lives of these purchases.
Cash flow statement — This will show the movement of money into and out of your business monthly. The cash flow statement is a critical financial model component because cash flow shortages can cause problems even for businesses that are profitable on paper.
Income projections — Also known as a pro forma profit and loss statement, this will detail your projected profit or loss over the next over the projection period. You’ll use the numbers from your sales forecast, expense budget and cash flow statement to complete these projections. The formula:
Net Profit or Loss = Gross Margin – Expenses, Interest and Taxes
Balance sheet — This will list all your company’s assets, or things you own; liabilities, or amounts you owe; and shareholders’ equity. Business assets typically include cash, accounts receivable, inventory, fixed assets (e.g., equipment, buildings and land) and intangible assets like intellectual property and goodwill. Liabilities include outstanding loans, interest payable and accounts payable. And shareholders’ equity is money attributable to the business’ owners. The formula:
Assets = Liabilities + Shareholders’ Equity
The financial page of your pitch deck should include a broad overview of projected sales, expenses, revenue and profits. But you can’t go into a tremendous amount of financial detail on a single page that’s part of a pitch deck, so you will flesh out the financial details in a separate financial model. Your financial model will consist of forecasts of sales, expenses, revenue and profits for the next one to three years that are based on solid assumptions, which in turn are based on market realities. A CFO services professional can help you create your financial model and effectively work it into your pitch deck.
Arthur F. Rothberg, Managing Director, CFO Edge, LLC