Financial models are a critical component of any venture. Modeling how you spend and earn money is the only way to know how much to ask for. A proper financial model also forces you to ask the tough questions about where each and every dollar is going. These models are also a critical component of The Startup Trinity.
Your potential investors need to understand that the money you are asking for has some basis in reality. Having a financial model sets that reality. It also is a tool for you to refine your ventures operations and run scenarios. In some cases, you may not get all the money you want. With a solid financial model, you can adjust accordingly.
Today, the best available tool to model your finances is a spreadsheet. Some financial packages (like Quickbooks) do have budgeting capability. The only problem with that approach is the learning curve, cost and inflexible input. You really can’t enter in equations nor can you format the output like you want it.
There are many schools of thought on granularity or details for a model. The level of detail will depend on your business and how much money you need. If the business is a coffee shop, single person consulting firm, dog walking business or restaurant, then the simple one month is a good start. For a more complicated business (like one that needs a significant amount of investment), a detailed monthly cash budget makes more sense along with a sales model.
Simple Model: One Month Cash Budget
The simplest financial model is a basic cash (Income/Expense) budget. In a startup, cash is king. So, understanding every single expense is critical. For a simple one month cash budget, follow these steps:
- Format Your Spreadsheet: The best way to organize the spreadsheet is to have income on the left and expenses on the right. See One Month Cash Budget for an example.
- Start With Expenses: List all of your anticipated monthly expenses. Start with things like rent, insurance, utilities, Internet, cellphone, etc. Once you have those down, then work on the salary and benefits. A common mistake most entrepreneurs make is they don’t pay themselves. This is neither practical nor a good idea. Running the business is your job. You should get paid for it.
- Estimate Production Costs: If you are making a product, on a separate sheet, calculate your Cost of Goods Sold (COGS). This will be your variable costs. Variable because they vary depending on your level of production. If you don’t make anything physical (like a car, meal, widget or whatever), then you can skip this step.
- Determine Selling Price: Don’t freak out too much. It’s an art to get the selling price right. You really don’t know exactly someone will pay for something until they actually pay for it. The best initial approach is to look at your competitors.
- Figure Out Break Even: The break even point is the amount of sales you need to generate in order to cover your fixed costs. Knowing this determines how many sales you need to shoot for. This is dependent on how much profit you make on each sale. The equation is: Break Even = Fixed Cost / (Unit Price – Variable Unit Cost). Check out this link for more details.
Once your cash budget is completed, it’s now time to double check your assumptions.
- Scrub through the entire budget and validate your expenses.
- Look at the sale unit break even point. Is it doable or completely insane?
- Compare your sales numbers to competitors. Is it roughly inline or vastly different?
- Have I under/over estimated expenses or price?
After scrubbing a couple of times, find a trusted (and willing) friend. Present the budget to them as if they were an investor. Explain your expenses, income and assumptions. Even if they have little experience with your business, the act of teaching them will flush out your assumptions.
Tip #1: When starting your business, it’s a good idea to have 3-6 months of fixed expenses in the bank. This “runway” will allow for operations while you build a customer base.
Detailed Model: Monthly Cash Budget
Similar to the One Month Cash Budget, except each month is independent. Ventures that need to develop a product before they can sell it, need a month by month budget to determine total capital required to launch the product. Initially, the focus should be on the expense side since sales will not happen till after the product is done. The method is the same as the One Month Cash Budget execpt:
- Format Your Spreadsheet: Expenses and income will be separate. Rows will be the expense category while the columns will be the month. You can take it out for as many months as you want. The typical duration is through product launch. See Detailed Monthly Cash Budget for an example.
- Start With Fixed Expenses: Just like the One Month, focus on your fixed costs each month. Copy those costs across to all months if you anticipate them not changing.
- Figure Out Variable Expenses: In this model, variable expenses can hit at different times. For example, if you need to buy a tool or software for a specific task.
- Determine Staffing Levels: Most companies ramp staffing up. The detailed month budget handles that well.
- Sum and Accumulate Monthly Expenses: Sum the expenses for each month them accumulate them over the months. This will show you how your cash burn rate varies over the months. It also allows you to figure out the total amount of money needed.
Initially, break even analysis for a venture that needs to develop products is not as critical. It still has to be done but only after you to the sales model. Sales modeling will be covered under a different post.
Once you have completed the detailed budget, do exactly the same procedure as the one month. Vet your assumptions with a trusted friend to ensure that nothing has been missed.
Using What You Created
Now that you have a solid cash budget, it’s time to put it to work. These expense numbers will be what you put in your pitch and executive summary for the amount of funds requested. It also gives you a good idea of your monthly burn rate, which most investors will ask you about.
Understanding your expenses will allow you to make informed decisions about potential setbacks. Knowing that your burn rate is X dollars a month give you a sense of how long delays cost you. Having a handle on the numbers will get you closer to success.
Check out this post for a list of financal modeling using Excel. I have not gone through the whole post yet but it does have several interesting links.