A well-constructed financial model is essential for building a successful business. It is critical for fundraising, forecasting, and making informed strategic decisions. But what exactly is a financial model, and how do you create one effectively? 

What is a Financial Model and Why is it Important? 

A financial model is a structured spreadsheet that forecasts and tracks your business’s financial performance over a set period, based on historical data and reasonable forecast assumptions.

At its core, it includes three main components: 

1. Revenue and expenses 

2. Cash flow 

3. Balance sheet 

These elements form what is often referred to as the "three-statement model." The financial model transforms these metrics into actionable insights through charts, graphs, and scenario analyses, providing a detailed picture of your business's likely performance. 

Laying the Foundations for Your Financial Model 

Building a reliable financial model starts with clear and realistic assumptions.

If your business has limited historical data, you’ll need to rely more heavily on external factors, such as: 

• Economic conditions: Interest rate trends, inflation, tax changes, and supply chain pressures. 

• Industry trends: Market size, customer demand, and competitor activity. 

It's essential to use credible information to underpin these assumptions. Public sources, financial news outlets, and industry reports can be valuable, though subscription-based market intelligence may also be worth considering. Experienced financial professionals can provide additional insights and access to high-quality data. 

There’s a useful list of the most popular UK business and economic websites here, some of which are behind a paywall.  

Key Uses of a Financial Model: 

A financial model serves two primary functions:

1. Business performance tracking: It helps monitor key performance indicators (KPIs), track budget adherence, and identify areas for improvement. 

2. Attracting external support: A financial model demonstrates your business’s financial health and potential, whether you present it to investors, apply for grants, or explore partnerships. 

Your financial model becomes a powerful tool for decision-making by documenting historical performance and aligning future forecasts with strategic objectives. 

How to Forecast and Manage Business Costs Effectively: 

If revenues are indispensable, costs are unavoidable. Understanding and accurately forecasting your costs is essential, especially in the early stages of your business.

Differentiate between:

• Fixed costs: Expenses that remain constant regardless of activity levels, such as rent or software subscriptions. 

• Variable costs: Costs that increase with activity, such as production materials or commission-based salaries. 

Additionally, account for potential hidden costs like bonuses, utility charges, or unforeseen operational expenses as well as allowing for inflation and other increases such as taxes (which often apply in April, at the start of the new tax year). It’s also wise to build best- and worst-case scenarios into your model to assess how unexpected changes—such as a drop in revenue or increased operational costs—could impact your cash reserves. 

Cash Flow Forecasting: The Core of Financial Modelling: 

Cash flow management is a cornerstone of financial modelling. Your model should forecast: 

• Cash inflows: Revenue, investments, and other sources of income. 

• Cash outflows: Operating expenses, supplier payments, and loan repayments. 

The cash flow statement categorises these into operating, investing, and financing activities to calculate net cash flow.

Analysing this data helps you identify cash surpluses or deficits and take proactive steps, such as: 

1. Accelerating invoicing and collections 
2. Offering discounts for early payments 
3. Negotiating extended payment terms with suppliers 

For SMEs, maintaining positive cash flow is crucial to ensuring business sustainability and building confidence among potential investors. 

Using Your Financial Model for Strategic Decisions: 

A financial model is more than a reporting tool; it’s a decision-making resource. For instance:

• Strong liquidity forecasts might support plans for new investments. 

• Projected revenue from a new partnership could justify scaling operations or hiring additional staff. 

• Identified risks, such as a potential cash flow shortfall, might indicate the need for cost controls or external funding. 

• Tracking key performance indicators (KPIs), such as investor KPIs or unit economics, is essential, especially for tech/SaaS and e-commerce businesses. These models should be designed to calculate and monitor metrics like customer acquisition cost (CAC), customer lifetime value (LTV), and churn rate, which are critical for evaluating scalability and efficiency. 

Regular updates to your model ensure it remains accurate and relevant as new data and business circumstances arise. While larger companies may review their models monthly, SMEs should do so more frequently to stay agile. 

Avoiding Common Mistakes in Financial Modelling: 

To get the most value from your financial model, avoid these common pitfalls:

• Overestimating revenues or underestimating expenses: This creates a misleading picture of your financial health. 

• Overly complex or imprecise formulae: Keep your model straightforward and accurate. 

• Inadequate validation: Double-check your inputs, formulas, and assumptions to avoid errors that could undermine the model's reliability. 

• Failing to ensure the model balances: Make sure the balance sheet remains aligned. If one assumption changes in one statement, it must flow through the other statements correctly without throwing the balance sheet out of alignment. 

Having an experienced financial professional review your model can ensure its accuracy and provide valuable insights to refine it further. 

Ready to jumpstart your financial planning? 

Building a robust financial model can transform the way you manage and grow your SME. If you’re looking for expert guidance or want to ensure your financial model is reliable, actionable, and investor-ready, our experienced financial professionals are here to help. 

Schedule a free consultation to jumpstart your financial planning by contacting us via Clientcare@efm.uk.com