Financial Modeling: Key Importance Tips to Build Your Winning Model

Financial modeling is a critical tool for informed decision-making and strategic planning for any business. Sam Altman, CEO of OpenAI and former president of Y Combinator, has emphasized the tendency of startups, particularly pre-Series A companies, to focus on urgent yet non-essential tasks, leaving little time for important but non-urgent activities. Among those vital but often neglected tasks are financial modeling and managerial reporting.

Modeling is decomposing a company's financial landscape by deconstructing any business model into a comprehensive list of metrics and further breaking down each of them into granular sub-metrics. I’m the COO of Refocus, an EdTech startup, and one of the challenges we've met was making our model truly informative. As soon as we managed to do it, our expansion became predictable, and we built a system on how to properly plan cash flows, hire timely, and scale various processes. So, whether you already have a business or are just planning to start one, a good model will become a game-changer –– and it’s not as hard to build as it may seem.

Unleashing the power of financial modeling

The primary purpose of financial modeling is to decompose a company's revenue into simple and measurable results. For example, let’s say you’re trying to predict your revenue for this year. The modeling will allow you to solve this complicated task.

Gross revenue is calculated by multiplying the price per unit by the quantity sold minus the VAT. While we have control over setting the price, the number of units sold depends on various factors. Quantity sold consists of leads processed and the lead-to-sale conversion. In turn, the number of leads processed is determined by the capacity of the sales team, which is influenced by the number of working days and the size of the sales force, including both existing and newly hired and trained salespeople.

As you see, a robust financial model benefits the entire company. The sales volume becomes the target for sales teams, while lead generation becomes the marketing team's responsibility. The product team's objective is to ensure the product is ready to handle an influx of new users.

Moreover, scaling requires expanding the customer success team, which in turn becomes the target of the HR team. In essence, financial modeling aligns the goals of the entire company. Moreover, it facilitates faster and more informed decision-making for founders, C-level executives, and management. It provides:

1. A clear visibility of the business drivers, enabling the team to focus on the most impactful metrics.
2. Transparent target metrics for each business indicator, such as lead-to-sale conversion rate, CPL (cost per lead), number of leads per period, number of new salespeople, refunds, and more.
3. An understanding of the overall business picture and the impact of the team's efforts: underperformed on hiring salespeople → missed the plan; acquired expensive leads → missed the profitability target; launched a subpar product → increased refunds → missed the net revenue target.
4. A clear cause-and-effect relationship by quantifying all changes in monetary terms.
5. Control of all non-driver-based overheads: percentage of product expenses relative to revenue and the scalability of back-office operations.

How to construct the model step-by-step

Construct a financial model in 3 steps:

1. Build the model’s architecture. It is a one-time process that determines what metrics should be included and to what level of detail you want them broken down. At the very basic level, it may take you no more than a couple of days. The architecture involves reverse engineering your business by deconstructing its components.

• Think about each component of your expenses and revenues: what are you spending money on, and how are you earning money?
• Break all of them down as granularly as possible. For instance, your monthly marketing budget cannot be calculated without knowing the number of leads your sales department can process within the given period. This value, in turn, is determined by the number of sales representatives in the department, the number of working days in the month, and the leads processed per day. Below, you can see an artificial example of how the marketing cost can be decomposed.
• Determine which level of decomposition is the most informative for you. The primary purpose of the model is to be convenient for your company. Try to create the initial version of the model and see if it allows you to make decisions. If you struggle, that’s a flag that further decomposition is needed.

2. Forecast based on historical data.

• Fill in the historical data from the past three months in your model.
• Make a forecast for the future based on the data while incorporating some growth assumptions. Start with your previous sales volume and conversion rates, and make slight improvements to reflect potential enhancements.

3. Iterate. Updating the data regularly, usually on a monthly basis, to keep pace with business changes is called rolling forecasting. Variations occur in business every day, and it is crucial to stay vigilant and adapt accordingly to keep your model working. For example, some of your sales reps or other employees may decide to quit, the conversion rate may decrease because of holidays, or the cost per lead may increase due to other unexpected factors.

As a result, you can derive the profit and loss (P&L) statement. It is one of the company’s most significant financial statements that showcases your business’s operating results. Creating and, most importantly, utilizing a detailed P&L allows you to analyze specific cost elements and determine where the profitability lies. Here, financial modeling serves as a means to generate a P&L, highlighting all the critical indicators to consider. This is what a part of the P&L devoted to content team expenses may look like:

Use the power of financial modeling fully

A company’s success is, to some extent, determined by strong decision-making. Having a financial model in place enables making numerous informed decisions quickly, thereby increasing the chances of your business to succeed. Investing a week in building a robust model is a task with tremendous ROI, as it provides the foundation for leveraging it in numerous ways over time.

Moreover, the financial model is a powerful tool in terms of fundraising. Usually, investors are interested in two things: how revenue is generated and how you plan to raise your indicators. In communication with potential investors, you should create a simplified, less decomposed version with actual numbers. If your model is over-complicated for people from the outside or you do not have one, your chances of securing investments will decrease significantly.\

So, don’t overlook financial modeling, and you’ll achieve sustainable growth.