If you aren’t using financial models for your startup, you’re likely to make decisions that invite losses or cause you to miss opportunities. You probably aren’t using a financial model template because you aren’t familiar with their potential for business growth. We intend to show you how to build a financial model for a range of business objectives, such as fundraising, talent acquisition, etc.
What Is a Financial Model?
It is a document you prepare in Microsoft Excel, Google Sheets, or similar software that uses historical business data and a set of assumptions to forecast your business’ situation in the future. Investors and lenders want to see a clear vision of your business in the near future before parting with their money.
Some pitch decks fail due to poor or no financial models backing. Even more importantly, you need to visualize future events that can affect your business. Investors want to know about these future risks and how you plan to mitigate them — They are the powerful tools that let you do this. Let’s see how to build and work with them.
How to Build Financial Models in 7 Steps
There are seven steps to building financial models, and they include the following:
- Collect necessary business data.
- Build a three-statement model.
- Decide what to forecast.
- List the key drivers.
- Decide who the model is for.
- Outline the model’s plan.
- Design the three key model sections.
1. Collect necessary business data.
If your startup has some data, you need to collect and organize those — both past and present figures are important.
Gather and organize your records on sales, costs, hiring, marketing data, etc.
Investment banking data can also be relevant.
How much money do you have in the bank?
What’s your business’s net worth?
You need all these for the input section of your startup financial model. Our financial model template has both plain versions and options tailored for Saas and e-commerce to make it as easy as possible for you to build a financial models.
2. Build a three-statement model.
Let’s examine the three building/foundational blocks on which every financial model stands. You can’t obtain feasible results unless your model correctly accounts for all three.
They include the following:
- Income statement
- Cash flow statement
- Balance sheet
Every financial model you build needs the three building blocks listed above. This is because some formulas or assumptions in your model will demand specific values that are obtainable only in calculations in the three-statement model. However, utilizing a financial model template can streamline this process and ensure accuracy in your forecasts.
Forecasting financial statements in Excel requires a solid understanding of your numbers, including cash flows. For example, if you don't know your sales, the percentage of new customers that return, and more detailed information such as CAC (customer acquisition cost), LTV (lifetime value), and revenue growth, how will you fill in financial models correctly?
Formulas and assumptions used in financial model vary depending on what the model tries to forecast. You don’t have to know all these formulas offhand, but the knowledge will speed up your work. Don’t bother memorizing them if you aren’t the academic type — the important thing is to ensure you haven’t left off any formulas critical to your calculations, as this may lead to the wrong results.
3. Decide what to forecast
Every model is designed to solve a particular problem or set of problems. You need a clear understanding of the problem your model would solve before you even open Google Sheets or Microsoft Excel. For example, if you want to know the impact of new hires on your future income and income statement, your problem statement may read something like this: the future impact of talent acquisition on income.
Regular financial modeling practice will make you more efficient in defining these problems.
Defining a purpose for your model simplifies the design process and saves you plenty of stress from mistakes. This is because the problem statement will guide your selection of key drivers and assumptions. Any model with an ambiguous problem statement is unlikely to achieve objectives like securing funding, allocating the budget, and scaling up in proportion to available resources.
4. List the key drivers.
You ought to know which factors are critical for your model to be as accurate as possible. For example, models for determining the most effective advertising channel require data on all channels used to advertise your product.
How much have you spent on individual channels?
How many people visited your website from Google, Facebook, Instagram, or LinkedIn ads?
What is the conversion rate for each advertising medium?
And so on.
5. Decide who the model is for.
Every good financial model is easy to understand for the right users. A model may seem complex to your accountant, who lacks the intellectual capacity to understand it, but easy for your marketing team to grasp, especially when dealing with cash flows.
For example, if your model predicts the future results of a new SEO content marketing campaign, you don’t send it to your accountant because that’s not their field; you send it to your marketing or SEO team, who can relate to historical data. Your accountant is unlikely to understand SEO or marketing jargon, so how could they use such a model in decision-making? Knowing who would use your model will enable you to simplify it to their level of understanding by using terms they can easily grasp.
6. Outline the model’s plan.
We’ve published several financial modeling best practice guidelines from which you can learn how to plan a model for your startup. A standard model must have three distinct sections: Input, Processing, and Output (more on these in the next section).
The first step in planning your model is identifying the minimum number of values needed for the input section. Try limiting the number of these values to keep your model simple. For example, if your model doesn’t require an “annual repurchase rate” as a KPI to produce useful results, you shouldn’t include it.
7. Design the three key model sections.
We previously mentioned the three arms of a financial model’s design, including:
- The input section
- The processing section
- The output section
Let’s see how to go about building each of these parts.
The Input Section
This part of your Google Sheets or Excel document is where, preferably, all inputs, including financial planning data, should go. The proper way is for all business data to go into the input part because if you divide the data section into two or more parts, the calculation gets complex, and following and auditing the model becomes more difficult.
You’ll usually find financial modeling experts trying to gather all raw data in the same place. Partitioning and consolidating the content of a model is the best way to get actionable results when forecasting financial statements in Excel.
It’s essential that the input area be as simple as possible but also covers enough factors to produce feasible results for decision-making. An input field that’s lacking typically yields nonactionable results. You shouldn’t start creating formulas while designing a financial model; complete the input component first.
The Processing Section
The processing segment contains all your formulas and assumptions. Since you’re predicting the future, you’ll use a lot of assumptions because you can’t get exact data for some values. For example, if you’re forecasting how many units of items to produce next year, you have to assume that the current demand trend for your product will continue unchanged.
No matter what forecasting formula or concepts you use, there’s no way to be sure about this. You just have to hope that nothing happens to adjust your trend arrow clockwise — by even a few degrees.
You’ll likely come across a financial model template or examples on Excel or Google Sheets that uses tools to protect the formula section so people don’t modify it without permission. These are formulas to which a slight change can widely swing the results.
There are no compromises when it comes to the accuracy of formulas. Assumptions should be as realistic as possible.
However, accuracy isn’t the only thing required in the processing area; formulas are usually arranged to make them easy to follow and audit. For example, avoiding multiple formulas in a cell, hiding cells, or using too many formulas when less will do are among the best financial modeling practice tips.
The Output Section
The output portion displays the results of your financial analysis. Usually, this section doesn’t need much work because it only displays results. You just have to make it modular or distinguishable so that different results can be clearly separated.
For example, when your model forecasts future costs, revenue, or losses, these metrics should display away from one another on the same sheet or, even better, on different sheets, especially when you build a large model expected to yield a range of distinct results. This makes it easier for users to understand your model and is more presentable to investors and money lenders. This is why many financial models offer pictorial output like charts and graphs.
Frequently Asked Questions
How do you create a financial model?
You can create financial model in Microsoft Excel or Google Sheets by completing the following steps:
- Collecting necessary business data.
- Building a three-statement model.
- Deciding what to forecast.
- Listing the key drivers.
- Deciding who the model is for.
- Outlining the model’s plan.
- Designing the three key model sections.
How do I create a financial model in Excel?
To create a financial model in Excel, you must first have a basic knowledge of the software/tool. You can create it in Excel on one or more worksheets but only start working in Excel after planning the model and preparing all the necessary input data. Create three distinct sections for input, processing, and output, using colors and empty cells to separate them.
Is it hard to build a financial model?
The difficulty of building financial model depends on your skill level. Typical financial modeling can take anywhere from 30 minutes to several days, depending on your skill level and the complexity of the model. A model that has many inputs and formulas will take longer to build.
Simple models, such as a three-statement model, don’t take long to design. However, if you don’t spend some time acquiring the skill, you won’t be able to build a financial model no matter how long you work on it.
What is 3-way financial modeling?
3-way financial modeling (or three-statement financial modeling) entails building a spreadsheet that shows your income statement, cash flow statement, and balance sheet. These three parts make up the building blocks of any financial model.
1. Income Statement: It outlines a company's revenues and expenses, showing its profitability over a specific period.
2. Balance Sheet: Balance sheet provides a snapshot of a company's assets, liabilities, and equity, reflecting its financial position at a given point in time.
3. Cash Flow Statement: Cash flow statement tracks the cash flow: the inflows and outflows, helping to assess a company's liquidity and cash management.
Combining these statements provides a holistic view of a company's financial performance.
Learning financial modeling can take time but is doable. If you want to seek employment with the skill, being certified as a financial analyst is essential. However, if you want to learn it for your business, we offer a comprehensive short-term course online.
Now that you have a clear picture of how to build a financial model, you’re ready to take advantage of this robust tool to grow your business. This article only summarizes the steps for creating a financial model; lots of calculations and assumptions go into the exercise. We recommend using our financial model template if you don’t have the time or patience to build one from the ground up.