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FINANCIAL MODELING

 

By the end of this week, you should understand:

· Why you need financial projections

· The difference between fixed and variable costs

· Your unit economics

· How much you need to make and sell to break-even

· How much money your project needs and when you need to raise it

 

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overview

 

A project’s financials are where you take all that you have learned about your problem, your customers and your solution and translate this knowledge in to cold, hard numbers.

Some people get very stressed about financials because they feel they need to predict the future with certainty. But the important thing to realize about financials is that you are just making your best guess about the future.

As Dwight D. Eisenhower puts it, ‘plans are useless but planning is indispensable’.  Financial plans are not meant to be perfect maps of the future, they are there to help you understand your business model and to help tell your story to investors. They can help you to spot threats and opportunities by helping you to answer questions like: should you raise prices because your margins are too thin or can you really afford to hire another staff member?

Do not worry if you are not the best at mathematics, we have made this guide very simple, so just follow the steps below. You will be able to quickly put together a solid set of financial projections!

 
‘plans are useless but planning is indispensable’
— Dwight D. Eisenhower
 
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assumptions

 

To create a financial model for your start-up, you will need to have answers to a lot of tough questions like:

How many units will you sell in your first year?

How much will you charge per unit?

How much will it cost you to make a unit of your product?

 

The truth is, as a start-up you really will not know the answers to these questions.

That’s OK. What investors want to see is that you have thought through these questions. Every business model is based on assumptions – the trick is to do enough work to make sure your assumptions are well informed. In the rest of this section, we will show you how to do that.

 
 
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projecting sales

 
 

TAM

There is a standard framework to help figure out how many sales you might achieve. First, define your total addressable market or TAM. This is all the demand for a product like yours, in your target country/region. For example, if you are looking at providing a small scale solar electricity solution in Nigeria, your TAM could be the total amount of money spent on electricity in a year.

 

SAM

Next, you need to define your serviceable available market or SAM. This market is all the customers you could theoretically serve with your current product and channels to market. Returning to the electricity example, your SAM might be the demand in all the small villages that are not connected to the electricity grid that have access to mobile data (so you can reach them with an internet campaign).

 

SOM

The final step is to define your serviceable obtainable market or SOM. This is the amount of the market that you are able to service and realistically expect to obtain in the foreseeable future.  Returning to our example, in this case, the SOM would be the number of places where your offer would be particularly appealing, e.g. small villages with sufficient infrastructure which are within a 200km radius of your headquarters.


Once you have identified your SOM, figure out how you are going to reach that level. First, figure out the price you are going to charge. This is where the work you have done engaging with your customers comes in. If you have gone through the steps in the earlier modules, you should have a pretty good idea of what your customers will be willing to pay but if you unsure what to charge, it is ok to use the price charged by your nearest competitor.

 

Next, figure out how much demand you are going to receive for your product or service, on a month-by-month basis for the first twelve months and then on a yearly basis.

 

Do not worry about being too precise before you have launched your business because you will learn a lot about how fast you can expand from trial and error. But try to think about what growth rate might be realistic based on what you know about your product, your process, and your competitors. For example, if it has taken your competitor six years to build a $1m business, you need a really strong case for how you will do things better and faster if you are proposing to create a $10m business in three years.

 

EXERCISE: PROJECTING SALES

 
 
 
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splitting out costs

The next step is to figure out what costs you are going to face. The best way to do this is to get everyone in the team to write down all the costs of production they can think of.

 

Now, split these costs into unit costs and overheads.

Unit costs are the costs directly associated with producing a good. They increase as the number of goods produced increases. In the textiles industry, the fabric that goes in to clothes is a good example of a unit cost.

Overheads are the costs that do not increase when the amount of units produced increases. Again, looking at the textiles industry, the cost of the factory is a good example of an overhead.

Many costs, such as wages sit in a grey area between being a unit cost or an overhead. If you increase your production a lot, you will need more staff, but you usually do not need more staff to produce just one more unit of a good. In this case a decision is necessary whether to classify something as a unit cost or an overhead.

As a general rule, when starting a business treat big costs as overheads. As the company gets larger you will be able to treat most of these overheads as unit costs.

EXERCISE: SPLITTING THE COSTS

 
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projecting costs

 
 

Now you have divided your list of costs into unit costs and overheads, rank your unit costs from largest to smallest. Then try to figure out what each of these will cost per unit of the product you are selling. There is a range of ways you can do this.

For example, you can ask experts in the industry, you can look up the financial reports of your publicly listed competitors or you can get suppliers to give you quotes

The key here is to prioritize – do not spend lots of time figuring out exactly how much something will cost if it will not have much of an impact on total costs. On the other hand, if an item will make up 80% of your total costs, you need to be really confident you have got the right value.

Once you know your unit costs, you can add these up and multiply them be the number of units you expect to sell in each period, in order to calculate your variable costs for each period

Now repeat this process for your overhead costs. In this case, rather than figuring out how much these things will cost per unit, figure out how much each of them will cost as a total. In some cases, this cost might change over time. For example, you may decide to hire another staff member after six month. This is perfectly fine, just be sure to reflect it in your budget.

Once you know your overheads, figure out when you will pay for them, and add them as a cost to that period in your model.[1]

 
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putting it all together

calculating your key metrics

 
 

Now you know your revenues, your unit costs and your overheads, you can calculate your profits and complete your financial projections.

It is important that you have a good grasp on your numbers because this is one of the key traits investors look for in founders. These numbers include:


Just because you have a functioning set of financial projections does not mean you should forget about your financial model. Instead remember your most important assumptions and test them at every opportunity.

Your financial plan is never complete – it is a living document which will grow and evolve with your business.

 

Your TAM, SAM and SOM

Your unit economics

Your cash burn until profitability

Your gross margin – i.e. the % of money you keep (before overheads) for each unit you sell. For example, if your product costs $10 per unit and your costs are $6 per unit, your gross profit per unit is $4 and your gross margin is 40%

Your break-even level of production

The number of years before you become profitable

 
 
 
 
 

common terms:

dive deeper resources:

 
 

asset – Something a business owns, benefits from, or has use of, that helps it generate income.

           

breakeven – The point at which cost and income are equal and there is neither profit nor loss.  

 

business model – A description of the way a business will earn the revenue projected in its plans.

 

financial model – A simplified representation that estimates how a business or project will perform under certain conditions.

 

fixed costs –  Business costs, such as rent, that [do not change] whatever the amount of goods produced. (see: variable costs)

 

industry averages – the average costs, prices

           

margin – The profit made on a product or service.

           

metrics – A set of numbers that give important information about the performance a particular business. These numbers are usually the set monitored by management and investors to see if the business is performing according to plan

                       

overheads - Overheads are the costs that do not increase when the amount of units produced increases.

 

revenue – The total amount of money that a business receives from selling its goods and services

 

SAM – Serviceable Available Market is the segment of the TAM targeted by your products and services which is within your geographical reach. (see: TAM)

           

SOM – Serviceable Obtainable Market is the portion of SAM that you can service.  (see: SAM)

 

TAM – Total Available Market is the total market demand for a product or service.

 

unit – A single complete product or service of the type that a business sells.

 

unit cost – Expenditure incurred in producing one unit of a good or service.

 

unit economics – The unit costs, price and unit margin your product or service

 

variable costs – Variable costs change with activity or production volume. (see: fixed costs)

 

Financial Model Templates  

A large collection of free excel templates

 

Financial Model for Startups: A Complete Step-by-Step Guide

A very detailed step-by-step guide to building a really comprehensive financial mode – great if you have some extra time on your hands

 

How to Create a Successful Financial Model

Some concise tips to keep in mind when building a financial model (but don’t buy their template unless your mentor advises you to)

 

 

18 Ways to Make Your Financial Model Stand Out to Investors

Tips for making your financial model stand out to investors

 

[1] Those with a background in accounting will be aware that we are effectively using a hybrid of cash and accrual accounting. This is to simplify things for those who are not familiar with these concepts.

If you are familiar with them, you can create a cash flow statement and a P&L statement if you prefer.