How to create a financial model for 1 year

What is a financial model and why should you create one with our free template in excel and google sheet

Importance of financial modeling for startups and small businesses

Creating a financial model is crucial for startups and existing businesses alike, as it helps in understanding the financial aspects of the venture. It provides insights into potential revenues, expenses, and overall financial viability. A financial model serves as a tool to assess the feasibility of the business idea and make informed decisions. It helps to evaluate current financial performance, make projections for the future, and identify areas for improvement. Financial modeling is essential for both startups and existing businesses as it enables better planning, tracking, and adaptability to ensure financial success.

How difficult is it really?

A quick assessment can be done in one day or even in an evening. An annual financial plan is the easiest, as you don’t have to account for price fluctuations and market changes on a frequent basis. However, the principles are the same for every financial model, whether it is for 12 months, 3 years or 5 years. 

The first time might take longer, but it’s better to invest time in the beginning rather than spending months on development and marketing, only to find out that no one is buying your product. 

To make the process faster, you can take a look at templates. Templates are highly useful for creating a financial plan, as they provide a structured framework, saving time and effort. With pre-designed sections and placeholders, templates ensure all essential components are included. They serve as references, offering examples and best practices. Templates promote consistency and standardization, enhancing professionalism when presenting the plan. In summary, templates streamline the process, offer guidance, and ensure a comprehensive financial plan.

What if I skip it?

Yes, you can. However, a financial model is something you create for yourself, for your own good. Prediction of revenue and expenses will paint a clear picture of your startup economy and let you understand how well you know how your business will function.

Skipping financial modeling can result in a number of risks for your business. 

1. Making poor or simply ineffective decision-making, because you do not have a clear understanding of business costs and revenue. If you do not clearly understand where money comes from, there is an increased risk of running out of funds for investing in the wrong product\idea.
2. Inaccurate budgeting and resource allocation. A financial model helps you estimate and allocate resources effectively. Without one, you may underestimate expenses and overestimating revenue, resulting in future financial hurdles;
3. Failure to achieve goals due to unrealistic expectations or difficulty in measuring success. A financial model allows you to set financial goals and benchmarks to measure the project’s success. Without one, it becomes challenging to assess progress, evaluate performance, and make necessary adjustments to achieve desired results.
4. Difficulty in securing funding without a financial model for due diligence, as investors and lenders almost always require a financial model to evaluate the potential return on investment and assess the project’s financial feasibility. 

Overall, it is certain that you can skip this step, however, you will run into more trouble than when making a good financial plan.

What tools should I use?

You could use simple Spreadsheet Documents. There are many software programs and you may use, however the most common are Excel Spreadsheets and Google Sheets. For filling your data or obtaining metrics easily use our free metrics database.

An example of a simple financial plan

We have created a simple financial plan to demonstrate how everything works. You can open it in Google Sheets or download it in Excel format, and look at all the formulas to understand the processes even better. You can also use it as a template to create a financial plan for your startup or business. 

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Business Model and Financial Plan

The key aspect when creating a financial model is to deeply understand the business model of your business. Understanding your business model is essential for creating a financial model that accurately reflects your business’s revenue potential, cost structure, growth strategies, and risk factors. It ensures that the financial projections and analysis are closely aligned with the underlying business operations and objectives, providing a robust foundation for decision-making, planning, and evaluating the financial performance of your business.

When creating a financial model, you should consider the following crucial points:

• Market Estimation & Competitive Analysis
• Balance Sheet:
  • Revenue Assumptions & Projections: This block focuses on estimating the revenue your business is expected to generate. It involves identifying the sources of revenue, pricing assumptions, sales volume projections, and any other relevant factors that drive your business’s income.
    • Breakdown of revenue sources (products, services, etc.)
    • Pricing strategy
    • Sales channels
    • Sales cycle and conversion rates

• Expense Projections: This block encompasses the estimation of various costs and expenses associated with running your business. It includes items such as fixed costs (e.g., rent, utilities) and variable costs (e.g., cost of goods sold, marketing expenses). Keeping expenses in check is crucial for understanding profitability.

• Gross Margin is a useful metric, that shows how much profit is generated from each dollar of revenue before considering other expenses

• Cash Flow Statement: This block tracks the movement of cash into and out of your business. It includes cash inflows from revenue, cash outflows from expenses, investments, and financing activities. The cash flow statement provides insights into the availability of cash and helps assess your business’s liquidity.

• Sensitivity Analysis: This block involves testing different scenarios and assumptions to understand the potential impact on your financials. Sensitivity analysis allows you to evaluate the sensitivity of your financial model to changes in variables such as revenue, costs, or market conditions, helping you identify risks and make informed decisions.

By focusing on these key blocks and keeping in mind your business model, you can create a simplified financial model that provides a basic understanding of your business’s financial performance, cash flow, and overall viability. After that, you can create a mode in depth financial plan. But remember, as your business grows and becomes more complex, you may need to expand and refine your financial model to include additional blocks and detailed analysis.

Market Estimation and Competitive Analysis

Defining the target market

The target market represents the customers that a business aims to serve with its products or services. Defining the target market helps a business to focus its efforts and resources in a specific direction and tailor its marketing strategies and messaging to the right audience.

1. B2B VS B2C

First, you can consider if you work directly with customers (B2C: Business-to-Consumer) or with other businesses (B2B: Business-to-Business). This main separation defines the distinct types of target markets based on the nature of the customer relationship and the nature of the business transactions.

If your business serves customers (B2C), you should consider factors such as demographics, psychographics, and buying behavior patterns and motivations of potential customers. For example, a business offering luxury skincare products might define its target market as women between the ages of 30 and 50 with an annual income of over $100,000 who prioritize high-quality and natural ingredients.

In case you provide services to other businesses (B2B), you should identify: Target Market, Industry or Sector, Company Size and Structure. A B2B target market could be digital marketing agencies targeting technology startups in the software development industry. These agencies specialize in providing comprehensive digital marketing services to assist startups in increasing online visibility and driving customer engagement. The target market comprises small to medium-sized software development companies that are in the early stages of their business.

2. TAM, SAM, SOM

It is helpful to create a more detailed view of the target market, using the division into Total Addressable Market (TAM), Serviceable Addressable Market (SAM) and Serviceable Addressable Market (SOM). These metrics help estimate the potential size and scope of a target market, allowing businesses to understand the maximum addressable market opportunity (TAM), the specific segment they can realistically serve (SAM), and the achievable market share within that segment (SOM).

• TAM represents the total demand for a particular product or solution within a specific market, encompassing all potential customers and their willingness to adopt the offering.
• SAM, on the other hand, refers to the portion of the TAM that a company can effectively target based on its resources, capabilities, and market positioning. It represents the subset of the market that aligns with the company’s target customer profile.
• Lastly, SOM denotes the company’s actual market share or the percentage of the SAM that the company can capture.

Discover market estimations effortlessly in our comprehensive metrics database, available to you at no cost.

Example 1

To illustrate these concepts, let’s consider a software-as-a-service (SaaS) solution for project management. The TAM for this solution would encompass all businesses and organizations that require project management tools, regardless of their size or industry. The SAM, in this case, would be the segment of the TAM that the SaaS provider can effectively target based on factors like the specific features and functionalities of their solution, pricing, and marketing strategies. For instance, they may focus on small to medium-sized businesses in the technology sector. The SOM would then represent the portion of the SAM that the SaaS provider is able to capture in terms of actual customers and revenue.

Example 2

Similarly, if we consider a market assessment for a new smartphone in the consumer electronics industry, the TAM would include all potential customers who use or have the potential to use smartphones. The SAM would be determined by factors like the target demographic, geographical considerations, and specific market segments the smartphone manufacturer aims to serve, such as high-end consumers or budget-conscious individuals. The SOM, in this case, would be the actual market share that the smartphone manufacturer can achieve based on factors like brand reputation, pricing, distribution channels, and competition.

Example 3

Here is a typical visual representation of TAM, SAM, SOM analysis:

Competitive Landscape Overview

Competitive Analysis is the process of evaluating and studying your competitors to gain insights into their strategies, strengths, weaknesses, and market positioning. It involves gathering information about your competitors’ products or services, pricing, marketing tactics, distribution channels, customer base, and overall business strategies.

Conducting a Competitive Analysis helps you gain a comprehensive understanding of the market landscape, identify opportunities for differentiation, and make informed decisions to effectively position your business and stay competitive in the market.

Visualisations always help to better understand the competitive landscape. For example, you can use a SWOT Matrix, make a table comparison of the features or draw a Competitive Landscape Map. For the creation of a financial plan this will help you identify your Strengths and Opportunities, assess Weaknesses and Threats, create a complete picture of the target market. You might find out that similar solutions already exist or understand that your product is truly unique, gain insight into the performance of similar companies and whether they receive funding.

Balance Sheet

A balance sheet is a financial statement that shows what a company owns, what it owes, and the value left over for its owners. It presents a summary of a company’s assets, liabilities, and shareholders’ equity. 

It includes: Expense Assumptions & Projections, Expense Assumptions & Projections, and Cash Flow Statement.

Revenue and Income Assumptions & Projections

Revenue assumptions are the estimations of a business’s expected income from its operations. You first have to think in general in what ways your business will generate money. Basically, assume what you can do and what people will pay for it.

After creating revenue assumptions, you can pass to the creation of revenue projections. Revenue projections are the specific numerical estimates of future revenue that are derived from the revenue assumptions. They provide insights into business viability, set targets, and aid decision-making. Regular updates are essential to keep projections realistic and adaptable.

First, you have to make assumptions of revenue. To do this, follow these steps:

1. Understand your Business Model: consider how your business receives income, through what channels and on what basis. 
2. Breakdown of revenue sources: A breakdown of revenue sources means understanding where the money comes from in a business. Basically, you need to figure out different ways a business makes money, such as selling products or services, getting paid for advertisements, or earning commissions. For example, a software company may have revenue from both the sale of the software itself and ongoing subscription fees. To make revenue assumptions with different revenue sources, you can follow these steps:
   • Identify your revenue streams, which could include multiple products, services, or other sources of income.
   • Estimate the revenue potential for each stream based on historical data, market research, and assumptions about future demand.
   • Allocate the revenue by source based on the estimated potential for each stream.
   • Analyze the revenue sources to identify any trends or patterns and to understand the relative importance of each source.
   • Monitor your actual revenue against your assumptions and make adjustments as needed.

Here is an example of a revenue source breakdown for a SaaS (Software as a Service) business:

• Subscription Revenue: This is the primary source of revenue for many SaaS companies. Customers pay a recurring subscription fee to access and use the software or service. The revenue is generated from different subscription tiers or pricing plans based on features, usage, or support levels.
• Upsells and Add-ons: SaaS businesses often offer additional features, modules, or premium services that can be upsold to existing customers. These upsells and add-ons provide additional value and functionality, generating incremental revenue.
• Implementation or Onboarding Services: Some SaaS companies offer implementation or onboarding services to help customers get started with the software. These services may include training, data migration, configuration, or customization. They can be a separate revenue stream or bundled with the subscription fee.
• Professional Services: SaaS businesses may provide professional services such as consulting, integration, or customization to meet specific customer requirements. These services are usually offered at an additional cost and contribute to the overall revenue.
• Transaction or Usage Fees: In certain SaaS models, revenue can be generated based on transaction volumes or usage metrics. For example, a payment processing SaaS may charge a small fee for each transaction processed through their platform.
• Licensing or White Labeling: Some SaaS companies offer licensing options, allowing other businesses to white label their software and sell it as their own product. This licensing revenue comes from royalties or licensing fees.

3. Pricing strategy: A pricing strategy is a plan that helps a business decide how much to charge for its products or services. It’s like thinking about the best price that customers will be willing to pay while still making enough money for the business to be successful. To determine the pricing strategy for each revenue source you can first research the market and determine your costs, afterwards set a profit margin (the leftover money that the business gets to keep as profit, after subtracting from you revenue all your costs), considering the target market. If you are able to, it is best to test your theory, and, if necessary, make crucial adjustments. It is important to regularly evaluate and update the strategy. For example, a company may offer a free trial period followed by a monthly subscription fee.
4. Sales channels refer to the different ways you sell your product or service, such as online, in-person, or through partners. For example, a company may sell directly to customers through its website or through partnerships with other businesses. 
5. Sales cycle and conversion rates: The length of the sales cycle means the time it takes for a customer to decide to buy a product or service. It’s the journey from when someone first hears about something to when they actually make a purchase. And conversion rates refer to the percentage of people who end up buying a product or service after showing interest. It’s the number of people who go from being interested to actually making a purchase. For example, a company may estimate that it takes an average of three months to close a sale and that 10% of leads result in a sale.

Discover sales metrics effortlessly in our comprehensive metrics database, available to you at no cost.

Examples:

• For an e-commerce business, the revenue streams could include sales of different product categories, advertising revenue from partnerships, and commission from third-party sales. 
• A consulting firm may estimate revenue from both project-based fees and ongoing retainer fees. 
• An e-commerce company may offer different pricing tiers for its subscription service and estimate revenue based on the number of subscribers at each tier.
• A B2B software company may sell through both a direct sales team and partnerships with other companies and estimate revenue from each channel.
• A company may estimate a 30-day sales cycle and a 20% conversion rate for its online sales.

A simple table of revenue projections can look like this:

Expense Assumptions & Projections 

Expense assumptions are the factors that you consider when estimating how much you will spend in the future. These factors can include things like the cost of materials, employee salaries, marketing expenses, rent, and utilities.

Expense projections are the estimated amounts of future expenses. They are calculated using the assumed factors in your financial model or budget. These projections help you predict how much you will spend and allocate your resources accordingly. Expense Projections are categorized in four main types:

• Fixed costs are expenses that remain constant regardless of the level of production or sales volume (rent or Lease Payments, salaries and wages, utilities, etc.). They are expenses that a business incurs regardless of its level of activity. To understand what your fixed costs are, find what your business has to pay no matter what. For example, a business might expect its fixed costs to total $500,000 over the year, including $120,000 in rent, $200,000 in salaries, $50,000 in insurance, and $130,000 in utilities.
• Variable costs are expenses that fluctuate in direct proportion to the level of production or sales volume (cost of goods sold, commissions, etc.). These costs vary based on your sales volume and should be projected accordingly. For example, for businesses involved in manufacturing or production, the cost of raw materials is a variable cost. As the production volume increases, the requirement for raw materials also increases, resulting in a higher cost. Conversely, if production decreases, the cost of raw materials decreases as well. As another example, sales commissions are typically based on a percentage of sales revenue. As the sales volume increases, the commission expense also increases. The commission paid to sales representatives or agents is directly tied to the level of sales achieved, making it a variable cost.
• Seasonal or Cyclical Variations in Costs occur in a predictable pattern over specific time periods. These variations are often influenced by external factors such as the time of year, economic cycles, or industry-specific trends. For example, if you are an owner of a hotel in the snowy mountains, you will spend more on advertising during the autumn and winter to attract more clients. Or a more complex example would be, that construction companies may experience fluctuations in costs due to changes in construction activity based on economic conditions. During an economic downturn, costs may decrease due to reduced demand, while costs may increase during an economic upswing.
• Expected changes in costs over time refer to anticipated fluctuations or trends in expenses that businesses can predict or forecast based on various factors. For example, a business may expect an annual increase in labor costs based on projected wage growth rates or anticipate higher costs for raw materials due to inflation in the industry. Or, for instance, an e-commerce business may anticipate higher costs initially to implement a new inventory management system, but expect long-term cost savings and improved efficiency.

Discover sales metrics effortlessly in our comprehensive metrics database, available to you at no cost.

Here are some examples of cost assumptions for a SaaS business:

1. Fixed Costs: We expect its fixed costs to total $500,000 over the year, including $120,000 in rent, $200,000 in salaries, $50,000 in insurance, and $130,000 in utilities.
2. Variable Costs: Our variable costs are projected to be $1.2 million for the year, including $600,000 in cost of goods sold, $400,000 in commissions, and $200,000 in advertising expenses.
3. Seasonal or Cyclical Variations in Costs: We anticipate that our advertising expenses will increase by 50% during the holiday season, which will result in an additional $100,000 in expenses.
4. Expected Changes in Costs Over Time: We expect our salaries to increase by 10% over the next year as we hire additional staff to support our growth. This will result in an additional $20,000 in fixed costs per month.

By making accurate cost assumptions in your financial model, you can ensure that your business has enough cash flow to operate effectively and make informed decisions about future investments.

Gross Margin 

When you figure out your income and expenses, you can calculate the gross margin of your project. Gross margin represents the percentage of revenue that remains after deducting the direct costs associated with producing goods or delivering services. It is the final calculation to determine how profitable your business is. 

Gross Margin (%) = (Total Revenue - Cost of Goods Sold) / Total Revenue 

The gross margin percentage is a useful metric as it indicates the profitability of a company’s core operations. It shows how much profit is generated from each dollar of revenue before considering other expenses. A higher gross margin percentage generally indicates better profitability and efficiency in the production or delivery of goods and services.

Cash Flow Statement 

While an income statement summarizes the revenues, expenses, and resulting net income or net loss of a business over a specific period, a cash flow statement provides information about the cash inflows and outflows of a business over a particular period. 

The cash flow statement captures cash flows from operating activities (e.g., cash received from customers, cash paid to suppliers), investing activities (e.g., cash used for purchasing assets, cash received from the sale of assets), and financing activities (e.g., cash received from issuing debt or equity, cash used for debt repayments).

• Operating Activities: This section of the statement includes cash flows from the day-to-day operations of the business, such as sales revenue, payments to suppliers, salaries and wages, taxes, and other operating expenses. It reflects the cash generated or used in the normal course of business operations.
• Investing Activities: This section accounts for cash flows related to investments in long-term assets or divestments from those assets. It includes activities such as purchasing or selling property, plant, and equipment, acquiring or disposing of investments, or lending and collecting loans.
• Financing Activities: This section focuses on cash flows related to financing the business, including obtaining funds from lenders or investors and making repayments or distributions. It includes activities such as issuing or repurchasing shares, borrowing or repaying loans, or paying dividends.
• Net Cash Flow: The Cash Flow Statement calculates the net cash flow by summing up the cash flows from operating, investing, and financing activities. It indicates the overall increase or decrease in cash during the period.

The Cash Flow Statement is crucial for assessing the liquidity, solvency, and overall financial health of a business. It helps in understanding the sources and uses of cash, identifying cash flow patterns, evaluating the ability to meet short-term obligations, and making informed decisions about financing, investment, and cash management strategies.

By analyzing the Cash Flow Statement, businesses can identify potential cash flow gaps, manage working capital effectively, and ensure they have sufficient cash to cover expenses, investments, and debt obligations. It provides valuable insights into the cash position and cash flow dynamics of a business, supporting sound financial planning and decision-making.

Sensitivity Analysis

A sensitivity analysis in a financial plan is a technique used to assess the impact of changes in key variables or assumptions on the financial outcomes of a business. It helps evaluate how sensitive the financial projections are to different scenarios, providing insights into the risks and uncertainties associated with the plan.

The sensitivity analysis involves varying one or more variables within a predetermined range and observing the resulting changes in financial metrics such as revenue, costs, profitability, cash flow, and return on investment. By doing so, it allows decision-makers to understand the potential impact of different market conditions, pricing changes, cost fluctuations, or other factors on the financial performance of the business.

The analysis helps in identifying critical factors that significantly influence the financial outcomes and highlights areas of vulnerability or opportunity. It enables businesses to make informed decisions, assess the feasibility of different scenarios, and develop contingency plans. Sensitivity analysis enhances the robustness of the financial plan by incorporating a realistic understanding of potential risks and their potential effects, aiding in strategic planning and risk management.

Variable	Base Case	Best Case	Worst Case
Revenue	$500,000	$600,000	$400,000
Cost of Goods Sold	$250,000	$240,000	$260,000
Operating Expenses	$200,000	$180,000	$220,000
Gross Profit	$250,000	$360,000	$140,000
Net Income	$100,000	$200,000	$20,000
Cash Flow	$150,000	$250,000	$70,000

Conclusion

Conducting a quick market assessment early on is a crucial step for entrepreneurs. By investing effort and time in understanding the market landscape, they can avoid the risk of investing significant resources into a product or service that doesn’t resonate with consumers. 

Implementing and using a financial model involves ongoing monitoring and evaluation. Entrepreneurs should regularly review their financial projections, compare them to actual performance, and make necessary adjustments to their strategies. This iterative process allows for better decision-making, identifies potential risks or opportunities, and helps maintain financial stability.

Regularly updating and revising financial models is equally important, as it ensures that the financial plan remains relevant and aligned with the changing business environment. By continuously updating and revising the financial model, entrepreneurs can adapt to changing circumstances, seize opportunities, and navigate challenges effectively.

In summary, creating a solid financial plan, informed by market assessments and accurate financial modeling, sets the foundation for a successful business. Remember, a well-crafted financial plan is not a one-time task, but an ongoing process that guides your business towards sustainable growth and profitability.

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