A few months ago we touched on the importance of having a forecasting model for your business. We’d like to delve a bit deeper into the subject and provide a more detailed guide that includes modeling best practices and Excel tips.
In general, there are two types of projection models: strategic models and operating models. To begin, strategic models are used primarily for higher-level presentations, such as for investors, and include the general direction of revenue and cost.
The first step in strategic financial modeling is to understand the business. This entails identifying the key business drivers that will impact the performance and financial projections. This is important because the level of understanding of the operations will serve as the basis from which to form critical assumptions for the financial model, and you would want that basis to be as robust as possible.
Understand the Business
If the projection is for a small startup, the owner may be the one who has to make the assumptions. For larger companies, relying on the executive team alone for assumptions runs the risk of having an incomplete basis for projections. Inputs have to come not only from the highest levels of the organization but also from the junior staff, including sales and marketing, who are on the ground and oftentimes are more connected with customers and have better insight.
Consider the Construction of the Model
Once you have the input, the next step is to consider the most reasonable way to lay out the construction of the model. Every business is different, so how you project revenue and costs is different. However, generally speaking, the math behind revenue would follow something along the lines of “price multiplied by quantity (p x q).” Try to decompose the key components that drive the product, its quantity and price. This will provide a good basis from which to project revenue trends. Revenue projections are also based on business landscape and confidence. Consider how big the space is, how many competitors there are. If you are running a startup in a very attractive space, there is certainly likely to be a huge growth potential; it is not uncommon for a startup to notch revenue growths of 100% or more in its early days, and projections can be aggressive. But also consider that these outsized growth rates naturally come down over time, and assumptions need to be toned down a few years into the business.
What are the Cost Drivers, Both Fixed and Variable
The next step is to think about the cost drivers, both fixed and variable, and to exercise projections for costs in each department of the organization. It is crucial to be conservative in estimating costs. Costs as percent of revenue may be higher in the earlier years and are expected to decrease over time. Many companies have net margins of between 15% and 25%. It may be a useful exercise to study the cost structures of larger, publicly traded companies that are considered sector leaders or standard setters. These can provide a very good model to follow as it is safe to assume that your cost structure could look like that of one of those companies once your startup or small business has reached a certain level of size and financial footing.
Review Data for Accuracy and Dependability
In any financial modeling, it is imperative that the underlying data are dependable and inputted accurately. Simple practices such as building in check points for data validation, keeping the spreadsheet neat, and utilizing tabs of a workbook can help create and maintain an organized and reliable model.
We will discuss the other type of financial model—the operating model—in the next article. Stay tuned!