10 Types of Financial Models for Startups

Managing risks and saving for the future need a regular financial condition assessment. Suppose you want to assess and anticipate how future events or changes affect your financial performance. In that case, you need to be able to notice cash flow patterns, identify problems, and implement solutions.

Developing a financial model helps an organization better predict its financial performance and make more informed decisions. Financial modeling aids in answering major concerns like:

• Company’s Net Profit Value
• Profitability of a new project
• Threats and opportunities in various scenarios

An in-depth familiarity with accounting, finance, and company KPIs is necessary for successful financial modeling. Keeping track of everything requires creative and logical thinking and a strong eye for detail. In this article, we’ll discuss the fundamentals and importance of financial models in decision-making and tools that assist professionals in navigating uncertainty, seizing opportunities, and building sustainable wealth.

Financial model

Most companies usually use their past financial and operational data as inputs in financial modeling. The financial models help understand the future and estimate revenue and expenses.

Let’s look at why understanding financial models is crucial for your business.

What is the Financial Model?

Financial modeling represents financial interactions and circumstances mathematically. It makes judgments by forecasting future financial performance using historical data, suppositions, and mathematical tools. Financial modeling is used in these sectors to assist investors, analysts, and managers in making sound financial and investment choices.

The steps of financial modeling include data collection, assumption development using past patterns and expert knowledge, model construction using mathematics, and interpretation of outcomes. It’s critical to check that the model’s assumptions are reasonable and account for the most important aspects affecting the organization or investment under study.

How do Financial models work?

An accurate financial statement model requires knowledge of the company’s operations, leadership, strategy, industry, and past performance. Thus, the first step for an analyst is to investigate the company’s context, including the market, goods, leadership, suppliers, and consumers.

An analyst uses this data to isolate the most critical factors influencing income and expenses and to evaluate the expected effect of pertinent trends like economic circumstances and technology advancements.

The analyst’s knowledge of the business’s core drivers and the analyst’s evaluation of future occurrences provide the foundation for the forecast model’s inputs. Rather than being purely mathematical or accounting tasks, financial models serve as a quantitative representation of an analyst’s predictions for a firm and its industry.

Sample Financial model for a startup company;

This table appears to represent the historical and forecasted data for a retail business, specifically related to the number of outlets, the average square footage per outlet, the total retail area, sales per square foot, and total sales.

Here’s a brief note to help you understand this data

Company started with 123 outlets in 2016 and is projected to increase to 321 outlets by 2023. It has fluctuated over the years, with the highest value in 2017 (8,510.64 sq. ft) and is expected to reach 8,647.36 sq. ft per outlet in 2023. It has steadily increased from 10,10,000 sq. ft in 2016 to an estimated 27,75,802.07 sq. ft in current year(2023) and increasing gradually each year, reaching an estimated value of 0.001098 . Sales have been consistently growing, from 809.25 crores in 2016 to an estimated 3,047.82 crores in 2023.

This data provides insights into the business’s expansion, its efficiency in utilizing retail space, and the growth in sales over the years. The projections for 2023 indicate continued growth in outlets, total retail space, and sales.

Why do we need Financial Models?

Financial modeling may help businesses of all sizes make better choices and more accurately forecast financial consequences when appropriately used. It requires original thought and skill in dealing with ambiguity and complexity to arrive at valuable conclusions.

Here are some of the most important reasons companies should use financial models.

• To begin with, financial models enable analysts to include business uncertainty in models and to simulate alternative scenarios to get insights into probable outcomes.
• Second, there are a lot of moving parts in the financial world, and they all have an impact on one another. Financial modeling lowers this complexity by analyzing the interrelationships and interdependence between many variables.
• Last but not least, financial models are organized frameworks that provide structure to otherwise unpredictable economic phenomena and market conditions.

Types of Financial Models

There is a wide variety of financial models that you should be familiar with. You can model the financial demands of your organization and make plans using these models, along with some familiarity with corporate finance and some useful templates.

Here is a list of models for your understanding.

The Time Value of Money (TVM) Model

The Time Value of Money (TVM) principle asserts that the value of money fluctuates over time owing to elements including inflation, the rate of interest, and opportunity cost. The value of a dollar now is greater than the value of the same dollar tomorrow. This idea is fundamental to making sound financial choices and assigning proper values to investments since it allows people and organizations to determine the fair market value of future cash flows.

Components of the TVM model

The main components of a TVM model are the present value, the future value, and discounting. The explanation of these concepts is as follows.

• Present Value – The present value (PV) of a future monetary amount is the total’s worth at the current time after being discounted at a specific discount rate. It is the value of a stream of cash expected in the future. The present value calculation goes as follows:

PV = FV / (1 + r)ⁿ

*FV= The future value
*r= The discount rate and
*n= The number of periods

• Future Value – The Future worth (FV) of a quantity of money is its expected worth after a set number of years of compound interest at a specific interest rate. You can calculate the value in the future using the following formula:

FV = PV * (1 + r)ⁿ

*PV= The present value

• Discounting – Discounting is figuring out the current worth of future cash flows using a discount rate. The discount rate considers both the opportunity cost and the investment risk.

Discounted Cash Flow (DCF) Model

The Discounted Cash Flow (DCF) framework is essential for calculating a company’s or an asset’s value. It projects cash flows into the future and applies a discount rate to bring them back to the present.

This method is flexible since you can use it for various assets because of its all-encompassing viewpoint and emphasis on intrinsic value. However, the value determined by DCF is sometimes delicate to input and assumption changes. Because of its focus on analyzing cash flows and intrinsic value assessment.

DCF is the foundation of investment decision-making. It facilitates cautious analyses of possible investments, albeit ignoring short-term market emotion.

Sensitivity Analysis and Scenario Modeling

To better understand how perspective changes in variables could affect financial results, scenario modeling and sensitivity analysis are crucial risk assessment methods. These financial models help evaluate the impact of uncertainty and make well-informed judgments under a wide range of conditions.

• Sensitivity Analysis – In a sensitivity analysis, you change certain input variables while holding others constant to determine the relative importance of each on the final result. To better manage significant risks, businesses must determine which variables affect their operations most.
• Scenario Modeling – scenario modeling investigates several potential future outcomes. It aids businesses in foreseeing the range of possible results for their bottom line. Companies may establish solid backup plans and respond more effectively to shifting conditions if they account for various possible outcomes.
• Impact Quantification – You can quantify the impact of various factors on financial indicators by using sensitivity assessments and scenario modeling. They make it feasible to put a number on the range of possibilities, giving decision-makers a more accurate picture of their risks and potential rewards.
• Stress Testing and Strategic Planning – Stress testing helps determine how well an organization can withstand adverse conditions. It is where sensitivity research and scenario simulation come into play.

By putting financial models through extreme stress tests, firms may discover weak spots and evaluate the effectiveness of risk mitigation procedures.

Monte Carlo Simulation

As a risk analysis method, Monte Carlo Simulation involves simulating many hypothetical situations to make educated guesses about the likelihood of various outcomes. Modifying input parameters following probability distributions enables estimating a broad range of possible effects.

This technique helps predict the likelihood of a project’s success or failure under various situations, which is essential for project risk assessment and portfolio optimization. Monte Carlo Simulation aids decision-making under challenging settings, allowing people and corporations to make educated decisions.

Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM) is a simple financial framework for predicting investment return based on risk. The components of a CAPM model are:

• Risk-free rate- Return on a safe investment
• Beta- The market sensitivity of an asset
• Market risk premium- The projected return on investment

The Capital Asset Pricing Model (CAPM) is a valuable tool for evaluating assets in terms of risk and return, which in turn helps with pricing and investment decisions.

By using CAPM as a framework for decision-making, investors may create portfolios that strike a good balance between risk and return. The financial model’s systematic approach improves the valuation of assets and ability to value investments.

Black-Scholes Option Pricing Model

The Black-Scholes Option Pricing Model represents a crucial equation for determining the worth of stock options since you can use it to understand option pricing and facilitate trading choices.

The model considers presumptions such as continuous volatility, no dividends, and market efficiency. The financial model determines the assumed worth of options based on its inputs, which include stock price, striking price, time to expiry, interest rate, and volatility.

The model may be used for various purposes in the complex field of financial derivatives, including hedging tactics, the value of employee stock options, and overall investment decision-making.

Revenue Forecasting Models

Organizations need reliable revenue forecasting models for accurate budgeting, planning, and decision-making. Accurate revenue predictions allow firms to deploy resources better and make more well-informed strategic decisions based on projected financial outcomes.

There are several different financial models for predicting future revenue:

• Time-Series – Time-series analysis forms the basis of this methodology, as it examines revenue data over time to uncover trends and patterns. You can predict future income by modeling the current trends.
• Regression – Income and other factors, including the state of the economy or advertising costs, are analyzed using regression models. Revenue fluctuations become predictable with the help of this model, which quantifies the impact of various variables.
• Market-based – Revenue is predicted based on the firm’s market share and expected growth rate using market-based models, which consider market trends, the landscape of competitors, and industry performance.

Financial Statement Modeling

Financial statement modeling helps with decision-making, appraisal, and strategic planning by projecting a company’s prospective financial performance. Making models for the three financial statements (P&L, Balance Sheet, and Cash Flow Statement) that interact with one another is part of this process.

Using projections of future financial performance, financial models are an integral part of the company appraisal process. They also aid scenario planning by letting stakeholders see how changing internal and external variables may affect the business financially.

These models are crucial for evaluating the effects of probable outcomes on a business’s finances and making well-informed choices.

Mergers and Acquisitions (M&A) Models

When gauging the viability and effects of a merger or acquisition, merger and acquisition (M&A) models are crucial. They benefit decision-makers by explaining these deals’ monetary, operational, and strategic ramifications.

One of the most important outputs of an M&A financial model is the pro forma earnings per share (EPS) for the merged company. Pro forma EPS measures the company’s earnings per share after the merger or acquisition.

It is calculated by combining the earnings of the two companies and then dividing by the total number of shares outstanding.

Let’s understand this by working with a very simplified example:

Assumptions:

• The acquiring company (say Delta Inc.) has 100 million shares outstanding.
• The target company (say Jilly Corp.) has 50 million shares outstanding.
• The Acquirer is paying $10 per share for the Target.
• Jilly’s EPS is $1.00.
• Delta’’s EPS is $2.00.
• Delta Inc. is issuing 50 million new shares to finance the acquisition.

Pro forma EPS calculation

Delta’s earnings:

• Pre-acquisition earnings: $200 million (100 million shares * $2.00 EPS)
• Post-acquisition earnings: $250 million ($200 million + $50 million)

Delta’s shares outstanding:

• Pre-acquisition shares outstanding: 100 million shares
• Post-acquisition shares outstanding: 150 million shares (100 million shares + 50 million new shares)

These financial models are helpful for quantifying synergies, calculating integration costs, and evaluating risks. M&A models use sensitivity analysis to determine the effects of modifying the inputs on the predicted results. They can help in planning integration by estimating the expenses to merge activities.

Unit Economics Model

The Unit Economics Model is a crucial analytical tool in assessing the profitability of individual units within a business. It delves into the relationship between the Cost to Acquire a Customer (CAC) and the Customer’s Lifetime Value (LTV). By analyzing these metrics, businesses can fine-tune pricing strategies, optimize marketing efforts, and ensure sustainable growth. This model is indispensable for making data-driven decisions and achieving a deeper understanding of the financial dynamics at the unit level.

Suppose a company spends $10,000 on marketing to acquire 100 new customers in a month. The Cost to Acquire a Customer (CAC) would be $10,000/100 = $100.

Now, let’s assume the average monthly revenue per customer is $150, and the average customer stays with the company for 12 months.

The Lifetime Value (LTV) would be $150 * 12 = $1,800.

In this case, the Unit Economics Model reveals that for every $100 spent on acquiring a customer, the company generates an LTV of $1,800. This positive unit economics scenario indicates a potentially sustainable and profitable customer acquisition strategy

Get your Financial Modeling done by experts of Eqvista!

Financial modeling is important to have a more accurate business picture. The purpose of financial models is to analyze and forecast a business’s or investment’s financial performance by representing relevant facts.

When building financial models, following the guidelines is essential to ensure accurate, consistent, and actionable results. You can now hand off the responsibility of financial modeling to Eqvista’s professionals.

In order to ensure that your financial analysis is accurate and follows your company’s goals, we will provide you with custom-tailored solutions. To get started, contact us!