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What makes a good financial model?

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A financial model is essential to running a business. If done properly, a financial model will help you to make strategic and operational decisions, and critically, it will tell you when you need to raise money. If done poorly, it will break your business. Cash is king, numbers are the foundations of your business, we can’t emphasise this enough, ignorance is not bliss.

So let’s talk about what makes a good financial model. Firstly, one size definitely does not fit all – every business, team, strategy, business model and industry, requires nuances in financial modelling which is why we never recommend using a blanket template. Templates can get you to the point of deciding if you have a business at all, but they shouldn’t be used for fundraising. In short, there are too many variables for each business that make a template model with no bespoke elements unreliable and mean it doesn’t tell the full story.

Whilst this article will not go into the financial detail of which KPIs or metrics to include for a specific business (we’ll save that for another day!), we will focus on the general characteristics that a financial model should meet.

The numbers should tie into the story being told.

A financial model should quantify the story being told by founders, from your go-to-market strategy, product roadmap, and hiring plan, to the size of the opportunity. For example, if you are launching a new product, are you planning on hiring the right team at the right time? If your sales are growing, does your model tell the reader the reason behind this (e.g. increased marketing spend, investment in a Growth Marketing team or a sales team)?

It should also be coherent. For example, say that you are telling an investor that the size of your industry will be worth £100 million in five years, does it make sense that you are aiming to achieve £80 million in sales in that same year?

Your assumptions show an investor how well you know your business: what are the key variables driving the performance, and which of those do you focus on and invest resources into – and which do you ignore.

It should be built properly.

The main question shouldn’t be “should I build one from scratch or can I use a template?”, but “does this financial model reflect the true dynamics of my business?”. In simple words, it should tell a reader how inputs go through a bespoke process and come out as an output, and how this process evolves over time. If you opt to have an external, experienced, party building your model (this is not a faux pas), you need to make sure you know how to use it and how to present it once it is built.

A financially sound model should comprise the three financial statements: Profit & Loss (P&L), Cash Flow Statement, and Balance Sheet. If your business is at very early stages you might get away with not including a Balance Sheet (although, most likely, investors will later ask to see it as part of their due diligence process).

It should forecast 3 – 5 years into the future, and forecast the operations of the business by month (by week is too detailed, by year is too high-level). It should also include historical financial data (if any), which is clearly labeled as “historical”, whilst the forecast is also labeled accordingly.

The model should be self-contained and only run in one excel spreadsheet. If you are linking multiple workbooks together, you are likely overcomplicating your forecast. There will be detailed and data rich components of your business (e.g. product engagement), but as a rule of thumb: if it doesn’t impact your costs or revenue, don’t include it in your financial model.

You’ll note that we do not recommend any financial modelling software. This is because this is quite literally the purpose of excel. There’s no substitute and nothing does the job better!

Finally, just as with any other document produced, it should have an “executive summary”. A good summary will include the main lines of the financial statements (primarily the P&L and your cash flow) as well as the main KPIs that drive performance. It is also very useful to include graphs/charts showing the evolution of these main KPIs and financial lines. The human mind is trained to recognise patterns so using graphics will feel more natural, even for those with a sound finance background.

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It should be dynamic.

The model should be built in a way that you can build different “what if” scenarios, so if you change key assumptions (e.g. marketing spend), they flow through the entire model. As a rule of thumb, the only numbers that should be hardcoded are historical and your assumptions; everything else should be a formula. The reason for this is twofold: i) allows you to run different scenarios to aid decision making, and ii) so when someone looks at your model for the first time, they can follow the logic by themselves and only question the reason behind the assumptions.

You should expect your financial model to evolve over time; the more you learn about the intricacies of your business, the more robust the information you have to include in your model.

You should be able to use it to raise money.

It is easier for everyone involved if the financial model you use operationally is the same financial model you use for fundraising. Down the line, once you have secured funding and (most likely) reshaped the composition of your Board of Directors, your Board will ask to see a comprehensive annual budget to sign off as the plan for the next financial year. For continuity, it will be much easier to use the same model to report to your Board (and other investors) as you did when you raised money and set the tone for your overall governance process and quality of assets going forward.