What does a good financial model look like?
Max describes how to make a sophisticated financial model simple and storytelling to both attract investors, and build their confidence in your ability to achieve your vision.
3 minute read
Once your deck sparks the interest of an investor - the next thing they will ask to see is the financial model. In its simplest form - a three-statement model that forecasts business performance. Realistically this model, when done right, will a) measure the correct unit economics to accurately forecast business performance and be adjustable to marginal changes; b) include detailed cost assumptions and capacity planning to demonstrate cash burn and; c) have a robust methodology to drive valuation.
Too often investors see forecasted ‘hockey stick’ growth curves and in today’s climate this will simply not pass the test. A good financial model will give investors confidence in your ability to deliver your vision and will support you sail through the due diligence process.
So how do you build a solid financial model? We challenge Senior Analyst Max Murdock to summarise the steps. Here’s what he said…
Start with the purpose, is it a management forecasting model or for growth funding promotion?
One is looking to track, monitor and forecast on a detailed level; the other is telling a data-backed persuasive story to support a valuation. Both are looking to create clarity and answer (rather than ask) questions.
• A common mistake is to overcomplicate. Simpler is clearer, easier to understand and defend. The model will never be perfectly accurate, it needs to show broad trends. By simplifying the information, a good financial model allows users to quickly grasp the key drivers and inputs that influence the outcomes. Use fewer assumptions, aggregate revenue streams and costs, simplify to the point you feel a bit uncomfortable for it!
• Key drivers and assumptions: The model should be built on a solid foundation of reliable data and assumptions, with every figure carefully sourced and auditable – ideally calculated from historical data. Many models fall down since the key assumptions (churn/revenue growth/customer acquisition costs) have been pulled from thin air to create a nice “hockey stick” graph.
• Outputs: Use charts and have a separate Output Tab - far better than number tables to spot errors, see trends and story-telling. Make the charts tell the story, e.g. Revenue and customer growth from increased marketing spend, Cost reduction from a restructure. By using clear and concise language, visual representations, and meaningful insights, a good financial model can effectively communicate the story behind the numbers.
• Explanations: Write in explanations for what a formula is trying to do, why a particular assumption has been used. You will save many hours looking back at a past model or for someone new coming to it. You will find and correct mistakes faster. You will realise (many times) that the current method is overcomplicating. If an investor cannot understand quickly why a particular number has been used they will view a risk and move on.
• Usability: Can you drop in the latest months financials and see the effect on forecasts? Can a third party easily navigate the model? Can you easily share the model?
The acid test is to hand the model to fresh eyes or someone not in the business and ask them the what the model shows, once they reply with the growth story or the key drivers in a management forecast, then the model is serving its purpose.
So whether you're an investor analysing a potential investment or a business owner planning for future growth, having a good financial model is essential for success.