The Complete Guide to Financial Modeling: Best Practices, Examples, and More
The perfect financial model can help you see into the future of your business. It can help you apply past trends to understand future performance, see what impact new assumptions would have on your outcomes, and outline quantitative for strategic initiatives. But building a financial model is no easy task. Here’s everything you need to know about effective financial modeling.
Whether you’ve been operating for years or are just getting started, your business has a lot of moving parts. Each piece — burn rate, valuation, cash flow — affects the next, and keeping tabs on it all can be tough. Add external factors into the mix, and things can get very complicated very fast.
You need a way to forecast these changes, a strategy to help guide your strategic decision-making and attract outside investors.
Enter, financial modeling — the backbone of a successful financial planning and analysis (FP&A) strategy.
Table of Contents
What Is a Financial Model?
A financial model is a way to consolidate the various parts of your organization. It’s a numerical snapshot that helps value your company, direct financial planning, and project financials into the future.
Financial models are typically contained in the finance team’s faithful spreadsheets found in Excel or Google Sheets, with different components connected through mathematical formulas. If the model has been built correctly, you can tweak a number — say projected revenue — and immediately see how that change would affect other aspects of your business.
Some of the primary uses of financial modeling include:
- Valuing a company
- Revenue forecasting
- Preparing for multiple scenarios
- Assessing the viability of mergers
Ultimately, the goal of financial modeling is to see how specific changes — whether they’re outside your control or not — will affect the company’s market position and bottom line today and in the future.
There are many different types of models. Different types focus on different financial aspects – some will be evergreen, models you want to continually utilize and update, while others will only be relevant at specific points in your company’s lifecycle.
A type of model that would be useful for one business — say, an investment banking firm — might not be quite as useful for an early-stage SaaS startup or a company focused on one-time purchases.
There’s no better way to show you what we mean than by looking at examples of financial modeling.
SaaS Financial Model Template
7 Types of Financial Models
The DCF or discounted cash flow model is used mostly for valuation. Gearing up for a new round of funding? This is the model you’re looking for.
The discounted cash flow model starts with projected future cash flows, i.e., how much cash the company expects to generate in the future. It then discounts these amounts to their net present value. This might sound a little strange, but it’s related to the time value of money ($1000 is worth more today than $1000 a month from now).
Specifically, DCF looks at free cash flow, and the discount rate would usually be the company’s weighted average cost of capital (WAAC), which is how much the company pays to finance its assets.
DCF also shows a company’s internal rate of return — the discount rate that would bring the net present value to zero. Venture capital firms and investment bankers like to look at this number before jumping aboard – the higher, the better.
Be aware, though, that DCF is not as useful for valuing SaaS companies. That’s because it doesn’t focus on recurring revenue or net revenue retention. In many cases, having no free cash flow is a normal part of a startup’s business plan, but it doesn’t mean the company is worthless.
We did say “mostly used for valuation.” The other big use is for gauging returns on capital expenditures – you can see how much a project is worth today based on its projected future revenue.
Three statement model
The three statement model provides an overview of the company by interlinking the “big three” financial statements: the balance sheet (for measuring working capital), the income statement (profit & loss), and the cash flow statement (inflows and outflows of cash/cash equivalents). The model can also include schedules like the debt or depreciation & amortization schedule.
Once you’ve built your three-statement financial model, you can test different scenarios. For instance, say you’re planning to make the leap to series B funding in the near future. You want to see how boosting advertising spend will affect operating cash flow, so you plug in a specific number to the income statement – say $50,000 – as well as a (reasonable) number for returns and series funding.
You see your operating cash flow decrease to less-than-ideal levels. You’d then plug in a lower number — if that’s too high, you’d go lower and keep doing this until you find that “sweet spot” number.
The three statement model is foundational not only because it’s the simplest model but also because you’ll need it to build more targeted models like DCF or LBO models.
A leveraged buyout is a purchase funded by sizable debt, with a very high debt-to-equity ratio. The LBO model shows the projected returns of that purchase, helping buyers – usually investment bankers or private equity firms – decide whether it’s worth the cost.
These are some of the most complicated types of models. Why? Because they use circular references and because there are so many different financing options.
A merger model projects what the new company’s financials will look like after a merger or acquisition. Specifically, it shows the earnings per share. If the earnings per share go up, it’s said to have accreted — if they go down, it’s said to have diluted.
In a spreadsheet, you’d divide this into three different cells. The first includes the acquiring company, the second the acquired, and the third shows the combined company.
Looking to go public? This model can give you a good approximation of what your IPO should be. To build your IPO model, leverage comparable company analysis and consider previous funding valuations.
Option Pricing Model
These assign a theoretical value to options, approximating their value. Is it in the money or out of the money
There are a few different types, including the binomial, Black Shoales, and the Monte Carlo simulation.
Sum of the Parts Model
This model is used for companies that have diverse business segments or many assets – companies too big for a (comparatively) simple DCF analysis. This model can also provide a more complete valuation than just DCF, as it includes marketable securities, real-estate holdings, and intellectual property (among others).
How To Create a Financial Model
There’s no one-size-fits-all way to build a financial model (no matter which type you’re trying to build). The steps below will give you the basic overview of how to build any model. But if you want a deeper dive into SaaS specifically, check out this episode of The Role Forward with Taylor Davidson, expert financial modeler and founder of foresight.is.
Without an objective – whether that’s valuation or seeing the effects of a specific event – your financial model will be useless. That’s why, before you get started, you’ll need to identify your goals.
What do you want to accomplish with this model? Do you want to build a response to specific scenarios, say a decrease in investor funding or a better-than-expected rollout? Do you want to value your company or find vulnerabilities and guide your budgeting process? Your answers will inform how complex your model needs to be.
Now, you’ll need to populate the model. There are two main inputs – historical data and assumptions. Different metrics will be important to different business and model types. For instance, the LTV:CAC ratio is critical for SaaS companies.
What are your assumptions? Are they backed by data like industry benchmarks and historical trends? Make sure to vet these before including them in the model.
Regardless of what type of model you’re building, you’ll need to look at headcount, top-line revenue, expenses, and the balance sheet — the four building blocks.
Build Your Model
Now, we get to the main event — actually constructing your financial model. We can break this down into several steps.
First, you’ll need to fill in your three financial statements.
Using the data and assumptions from the last step, build forecasts to chart your revenue growth rate. These aren’t just one-time expenses. SaaS companies need to track monthly recurring revenue (MRR). If possible, break that down into customer segments and pricing tiers.
Financial models should be easy to understand. After all, it’s not just the finance team that will be using it. A valuable financial model needs to be able to help the whole company, from the CEO to the marketing and sales teams. That means your financial modeling design is just as important as the data that goes into it. Follow a logical structure. Highlight aspects of interest to investors and decision-makers.
Clearly mark drivers and assumptions. Use color coding — for instance, you might use black for formulas and blue for hard-coded input cells.
At the same time, make sure you don’t overwhelm — it’s easy to want to include as much detail as possible, but financial models should get to the point as quickly as possible.
Test & Refine
Once the model’s built, you can put it into action. If anything is obviously way off, you’ll know there’s an error. Backtrack through the previous steps and make any necessary corrections.
You should constantly update your financial modeling based on new data and changing assumptions. You can also perform sensitivity analysis to see how vulnerable your assumptions are to inaccuracies.
The Importance of Quality Data and Technology
A financial model is only as good as the data it’s based on. It’s not hard to find examples of companies that have been over or undervalued based on flawed data. Worse than that, a flawed model could lead a company in the entirely wrong direction. We can’t overstate the importance of ensuring data sources are solid, then checking and rechecking.
Finance's Complete Guide to CRM Hygiene
What could be more solid than your company’s own internal data, recorded automatically?
That’s exactly what Mosaic does, making it much easier to build these complex models. The financial modeling software will automatically generate a baseline scenario, which you can then iterate on with different business outcomes.
Technology helps not only with modeling, but also in ensuring the data is valid and up-to-date. Especially for startups, models need to be flexible. Remember the four building blocks? Mosaic gathers them all by integrating with your HRIS, CRM, and ERPs.
All of this information is presented in real-time, so that outputs reflect your company’s current, down-to-the-hour situation. You have a complete solution for projecting, visualizing, and then acting upon that information. A connected piece are financial dashboards. Similar to a dashboard in a car, a financial dashboard provides a simple, visual summary of relevant KPIs, showing if you’re “on-track” to achieving your objective
Advanced Financial Modeling Techniques
We’ve covered the basics — what about more complex maneuvers?
The most useful is scenario planning. Why? Well, because it will reveal critical vulnerabilities in the company. To find those vulnerabilities, you ask “what-if” questions like: What if the economic scenario completely changes? What if our new product doesn’t sell as well as we’d planned, or new regulations affect our industry? Think of it as your personalized financial playground.
Mosaic makes it easy to do scenario planning by generating baseline scenarios based on your company’s headcount, revenue, balance sheet, and income statement. From there, you can stress test these different levels.
All of this is made even more helpful when you bring AI into the picture. AI can analyze data, uncovering trends that wouldn’t otherwise be obvious. It refines your basic financial models and scenario plans, adding a level of mathematical validation that wouldn’t otherwise be possible.
Mosaic’s Role in Scenario Planning and Financial Modeling
Building financial models tailored to your business is a critical part of strategic FP&A. But many businesses find it too difficult to do, or make mistakes that seem like a good choice but aren’t (financial model templates, we’re looking at you).
The best way to get around that time-consuming, difficult process is to utilize software — software that makes it intuitive to build financial models that answer any question you could imagine.
Take the guesswork out of your modeling process by building financial models based on your own data. Get a demo of Mosaic today.
Financial Modeling FAQs
What is the difference between financial forecasting and financial modeling?
On the face of it, financial forecasting and financial modeling sound very similar. Both project your business’s performance into the future, help guide decision making, and are quantitative rather than qualitative.
The difference lies in how they’re used.
Something like a cash flow forecast would be used as a tool in day-to-day, month-to-month operations. The goal would be to optimize liquidity and ensure you don’t hit any shortfalls.
Financial models, on the other hand, build a more complex simulation of the entire picture. They look quarters or even a year or two down the line, to determine what the company’s financial position might be — down to equity, assets, and — if you were to take a certain action, or a certain scenario were to impact, right now.
Forecasts are like a 2-D map of your state, while financial models are a 3-D map of the entire country.