How to apply financial modeling when building a business

Austin Buckett, Director and CFO at BiggsKofford, explains why it’s never too late to put together a good financial model that can promote your company to investors and guide your business decisions:

Building out a financial model is one of the most critical steps in launching a new business, but it is also one of the most commonly overlooked steps along the path from idea to income-generating operation.

Whether you are just starting the process of launching a new business or deep in the entrepreneurial game, it’s never too late to put together a good financial model that can promote your company to investors and guide your business decisions.

What is Financial Modeling?
Financial modeling is the foundation that supports any solid business plan.
Before you can understand how a business will run, you must first have a rough idea of where the revenue and profit will come from, which explains why having a robust financial model is a critical component of any good startup pitch.
Most startup investors have a long list of business plans that they could consider funding. The financial model is often the difference maker that gets those investors to dig in and read one business plan out of the stack of options on their desk.
When reviewing a financial model, you must keep in mind that all of the numbers involved are strictly theoretical. If the experience from actually running your business proves your model wrong, you will need to make adjustments.

How to Build Your Financial Model
Even the best financial models are built on several assumptions, but that doesn’t mean you don’t want to have the very best possible guesses feeding the model you create.
The first step in building a solid financial model is calculating the size of the market your business is targeting. This will give investors a ballpark idea of the ultimate potential of the company.

The next step in building a financial model is to break down the unit economics of whatever your startup will be producing, including the estimated selling price of a unit and what you expect the production costs to be.
Once you have estimates for your market size and unit economics, it’s time to define and estimate your fixed costs to calculate your overhead. After that, you will also want to project the number of sales you are expecting and how you believe those sales will grow over time.

The best financial models will also include an analysis of a customer’s lifetime value, which will involve some assumptions on how frequently you can expect them to purchase your products.

Tips for Keeping your Financial Model Focused
Building out a financial model for a new business can become a massive undertaking if you aren’t careful, so the most important tip for keeping your model focused is to dig deep into the details without overcomplicating the secondary information.
It can also help to define the Key Performance Indicators that you will utilize to evaluate your business. This will give you an understanding of what you will need to do to improve your business once the live sales information starts to come through.
Another way to help keep your financial model focused is to stress test it with a wide range of hypothetical scenarios and evaluate which areas could be made simpler or more robust depending on how it performs.

Common Financial Modeling Mistakes
Like any business practice, there are many mistakes that you will want to watch out for when developing your financial model.
One of the most common mistakes is using numbers that aren’t realistic. To avoid this problem, make sure that you consistently base your input numbers on comparable businesses in your industry.

Another common mistake that people tend to make when building financial models is forgetting to factor in potential problems that could invalidate the numbers that feed into their model. Make sure that you aren’t looking at your business with rose-colored glasses when forecasting its potential.

Failing to define inflection points where cash will be injected is another common mistake you will want to avoid. It is essential to be as transparent as possible with investors regarding future funding rounds.

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