How and when to start building your first financial model

Sophie Conaghan

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Pre-Seed
Seed

This guide sets out my recommended approach to starting your first financial model

Whether you are pitching to a potential investor or reviewing performance as a leadership team, you will need to have plans, variance reporting and analytics to hand that you can interpretand make decisions from.

Setting out the key metrics / drivers around revenue, costs and cash that are going to make your business grow, and how you can control them in a narrative form, will allow you to translate your growth plans into a financial model.

You can then use this model to start to plan more strategically; to plot out different scenarios and make decisions about where to invest in order to get where you want to go.

The best place to start – before opening a spreadsheet – is to build a narrative around your business that articulates your business model. This should cover:

Revenue model
Investment choices
cash flow timings.

1) Start with your revenue model🔗

You generate revenue when you sell something to a customer for a price. Those customers come through a marketing and sales funnel, which details how revenue is generated by laying out the following stages: Market > marketing > leads > sales > customers > pricing > revenue.

When detailing your revenue model, here are a few example questions to ask yourself:

What is our product(s)?

What is our market?

Who are our customers?

Where are our customers?

How will our customers find us? (What is our marketing strategy?)

How many leads can we reach?

How will we convert a lead to a customer? (What is our sales process?)

What will each customer buy? (e.g. a mix of products, number of units, average basket size)

How does our pricing work? (What is our pricing strategy?)

2) Articulate your investment choices🔗

Think about what you are going to need to spend your money on. Use the sales and marketing funnel as a guide and ask yourself the following questions:

What marketing activity will you carry out?

What paid channels do you intend to use?

How much do you plan to spend on each activity/channel?

Is someone dedicated to marketing (people cost)?

Think wider in your business as well. Go beyond obtaining customers. For example:

How do customers get access to the product?

What are the associated access costs?

What are our hosting / payment processing fees?

Physical delivery costs?

Always consider the question: How will this spend drive revenue?

3) Articulate your cash flow timings🔗

Cash flow timings do not always match the timing of the revenue and costs which sit in your Profit & Loss Statement.

Make sure to consider these different timings. For example:

The cash required for upfront stock/inventory purchases in a retail/e-commerce setup
The cash required for the research & development phase in a robotics/medical setup
The cash required for paid marketing channels which you can expect to see a future return on through customer leads
VAT

4. Architecture, logic and outputs🔗

Once you are clear on your narrative you can begin building a financial model in your chosen tool (see below: A note on tools). Here is a simple suggested process for this:

1) Design the architecture – Plan the structure of your document.

What time period are you modelling for
What key milestones and timings from your business plan do you need to reflect eg timing of new products - development stage and launch stage, timing of expansion into new geographies, plans for new premises and staff hiring etc

2) Input the logic

Identify the key drivers in your business model of Revenue, Costs and Cash Flow -it’s great to really “get under the bonnet” early and try and work out what is driving the financial results of your business and how you expect those to change over time.

3) Discuss and agree the viability of outputs

Once you have added logic into your architecture and created a first version of a model that shows total Revenue, Costs and Cash Flow over time, review the overall picture it has created. Is the cash low point as expected? do you feel secure with the predicted cash runway?

A note on tools for building a financial model

Once you are clear on your narrative, you can begin building a model in your chosen tool. Spreadsheets can be a good way to do this, as they give the most flexibility for building a model but the blank space can be overwhelming, there can be a learning curve depending on your knowledge of formulas and the tools available, and a lack of in-built intelligence does mean excessive time spent manually populating cells.

One tool I recommend is Ca us al.app, a business planning tool that works like a spreadsheet but with the intelligence behind it to instruct and duplicate logic (e.g. replicating your logic for different products or geographic regions), which makes models faster to build. It also has functionality and integrations to allow real-time reporting of plans versus actuals – but that’s a whole new topic! If you enjoy trying out new tools and have the budget, this could be a route to consider, but bear in mind you will need to dedicate some time to learning the platform.

A simple spreadsheet structure to use is this:

Columns = time periods
Rows = categories
Across it all = timing of milestones, events, contracts

Other key considerations – VAT and accruals accounting🔗

VAT

Once you are registered for VAT you have an obligation to file regular VAT returns with HMRC. The returns are filed in arrears which means that you both charge VAT to your customers (add VAT to their invoices) and pay VAT on your purchases (on the invoices your suppliers send to you) before submitting a VAT return to HMRC.

This means that you need to make sure that you always have enough cash in the bank to repay HMRC when the time comes.

Example

You start with £0 in cash

In Q1 (Quarter 1 of the year) you sell £100,000 of goods and charge your customers £100,000 + 20% VAT (£20,000)

You have collected £120,000 in cash

In the same quarter, you make £120,000 of purchases from your suppliers and spend the whole £120,000 cash you made from sales

You now have £0 in the bank

The £20,000 VAT is due back to HMRC at the end of the your current VAT reporting quarter

But now you don’t have enough cash in the bank to repay HMRC…

Accruals Accounting🔗

There are two types of accounting; cash accounting and accruals accounting

To get a true picture of your revenues and costs by month you should use accruals accounting.

Don’t worry too much about understanding this in detail but do know this:

If you make sales of a good or service that is delivered over more than one reporting period (the most common period is one month) then you should only recognise the portion that belongs to that reporting period and DEFER the rest.

Example:

Your business model is to tell software as a service on both monthly and annual plans

A customer signs up for a year and you will deliver the software to them every month

The customer pays £120,000 upfront for the annual plan

Even though you have received £120,000 in cash upfront, you can’t recognise all of this as revenue in the month

Instead, you recognise it equally over the period in which you will deliver the service, so in this case, over 12 months ie £10,000 a month

This concept can be tricky to understand from reading a single article. If you’d like to discuss accruals further to make sure that you understand it and how it impacts your business, follow the link to my Calendly at the bottom of this article.

Start simple, and keep it simple

You don’t need a full-blown complex financial model from day one. As your business evolves, different formats for the model will follow. For example:

Early on: Being able to articulate (as per the above) in narrative form is a huge step to take and will clarify both for you and any readers what you are planning to achieve financially.

Follow this with: A simple table setting out the key metrics / drivers around revenue, costs and cash, that are going to make your business grow, with a narrative around how can control them is a great start point.

Develop this into an annual (or monthly, depending on how quickly key metrics are expected to change) plan

As your financial model evolves, remember to keep it as simple as possible. Once you start speaking to investors and they want to see a model, they need to be able to pick it and quickly understand it. An overly complicated model does not mean that your business is more sophisticated and interesting, but it does mean that an investor will struggle to understand it (and it is more prone to error).

You are not expected to have a fully resourced finance function from day one. As with all other functions it will evolve as your business grows and needs change. But you need to be aware of the choices you have in how you resource the function and be able to engage and hire specialists who are best placed to fill your needs. There is not a one-size-fits-all approach to designing your finance function - you can design it to best suit your needs and the needs of your business as it evolves.

Being able to articulate the key metrics / drivers around revenue, costs and cash that are going to make your business grow, with a narrative around how to control them, is a great start point and will clarify both for you and any readers what you are planning to achieve financially.

If you would like to discuss your unique business model, get in touch for a free no obligation chat covering business revenue model, the key accounting concept of accruals, consideration for the key inputs and basic architecture of a financial model and more: www.calendly.com/sophieconaghan