The nearer you get to putting a shape on your start-up idea, the greater the need to put a ‘financial picture’ together of what the business will look like. The ‘financial model’ shows the money version of the plan.
There is a nature to every business and business idea, and the ‘financial model’ should reflect this – is it a product, a service, a licensing deal, a manufacturer, a distributor or something else? The model should show the financial calculations and the expected results of how it is intended that the business is set up and operated to make a profit and generate money.
Financial modelling is used all the time. Done well, the financial plan will completely answer all the questions asked of it, in terms of drawing a predicted picture of the future.
And yet – financial modelling can be one of the sloppiest pieces of work ever assembled! They can be rife with errors, miscalculations and hideous assumptions. When you drill into why the model does not work, you will find that the basic ‘rules’ of financial modelling have not been followed.
These are the eight rules of preparing financial projections:
MS Excel is your palette. Columns are for months, rows and sheets are many – spread out your calculations and as they say in the exams – show your workings!
Use formulae! There are certain numbers that are the ‘source,’ and all else flows from these sources. Use formulae throughout, so that the projections automatically adjust when you change the source values. Typed-in values kill spreadsheets – fact!
Make it whole! Projections consist of a Profit & Loss Account, a Cashflow and a Balance Sheet. Not just one or two parts, but all three parts. And they need to be made to link together and interact with one another.
Profit & Loss Accounts show how sales are calculated, make the link from sales to the directly related costs and tabulate the overheads, leading to a profit (or loss).
The Cashflow shows ‘Money over Time’ – it reflects the reality of when money comes in (relative to, say, when the sale was made) and money goes out (when, say, a supplier comes due for payment). Money comes in and goes out at different times. The Cashflow shows these different timings. The Opening Balance, plus what comes in, less what goes out, is what is left. If this falls to Zero (or below!) – this means we need more money.
The (often-left-out) Balance Sheet in a projections model shows the Value of the Enterprise. It shows the assets in use, the Working Capital (short-term assets less short-term liabilities) and the long-term Debt. The sum of these bits is the Enterprise Value. It is what the shareholders get. If it is going up in value, then progress is being made. Watch for the pitfalls – if it does not balance or if the value of Working Capital is changing (at a quicker rate than expected) – something’s wrong in the assumptions or the calculations elsewhere in the model.
Build a Summary Table, with links to the model. Show the key results (Sales, profit, cash, working capital, for/at each year-end). Include the ‘source’ values here, so that they can be changed (up and down).
Make it neat! Use formatting, underlines and neat layout to make the model easier to read. Use graphs to visually display results. Delete redundant workings and figures. Being easy to read and interpret helps identify any mistakes at the preparation stage.
John Eager is a Chartered Accountant and Principal of WinAbu Consulting. John works with the KAUST Entrepreneurship Center, advising start-ups and helping to model the financials. John is one of the International Mentors for KAUST’s REVelate program.