Every startup needs a forecast to plan for the future and make better decisions. Regardless of whether you use software tailored to financial modeling or a spreadsheet application, there are 5 key elements every forecast should include.
1. Patterned after your business model
You need your forecast to be patterned after your business model or else it won’t be a realistic predictor of the future. Taking the SaaS model as an example, if your forecast model neglects the recurring nature of subscriptions, you’ll fail to see the true growth – and cost – of your efforts to acquire and retain customers. The best way to ensure your financial model is based on your business model is to answer the following questions:
What are the key drivers in my business?
What expenses do I expect to scale with revenue?
How do I plan to increase my revenue in the future?
Your financial model should include answers to these questions, so you can understand what drives your business and make projections based on those drivers.
2. Based on historical data
All financial models make assumptions regarding the future. The best kind of assumptions are ones that can be defended by historical data. The best case scenario is that your assumptions are based on your company’s historical performance. When you don’t have any historical data, however, it’s best to use the historical performance of other companies in your industry. Obviously, you won’t have access to the financials of your competitors, but you can ask your accountant, board members, or other founders in your network what reasonable assumptions are when building your first financial model.
If you can’t track your forecast to your actuals, it’s just a really complex calculator. At the bare minimum, a financial model needs to be able to be tracked against your actual revenue, expenses, and cash flow. What distinguishes good models from great models, however, is if your assumptions can be tracked. What’s the use in making a sales close rate assumption if you can’t compare it to actual data?
The ideal state of any financial model is to have every assumption in the forecast measurable with actual data, so when your forecast is off, you can pinpoint the exact reason why. For example, if you miss your revenue target, you need to answer the question of “why.” If you can track every assumption you made in calculating their revenue target, you may find that the number of inbound leads was lower than expected, or perhaps your average contract value assumption was too high. Having this level of insight into your financial model will help you identify strategic initiatives in your company and make better forecasts in the future.
A dynamic model is one that can easily be adjusted to create various scenarios of what the future may look like. The industry term for why you need a dynamic model is to perform sensitivity analyses. A sensitivity analysis enables you to see how sensitive your forecasts are with changes to your assumptions. If recent history has taught us anything, it’s that you need to be prepared for anything, and a sensitivity analysis enables us to plan for multiple scenarios. You may want to model a scenario where your company sees increased costs due to supply chain issues. Or you may want to stress test your forecast by taking growth to zero and seeing how long you could operate. Or you may want to plan for a round of fundraising and model how much money you should take to achieve different milestones. A great financial model makes it easy to plan for any scenario without having to create a brand new model. Even better if that model also allows you to compare those scenarios against each other, so you can determine the best plan for your company moving forward.
5. Simple and easy to use
Finally, a model should be easy to use and maintain. Most forecasts are created on a monthly or quarterly basis, and complex models make those forecasts painful and time consuming to create. A forecast is only useful if it’s followed by execution, and the longer forecasting takes, the less time there is to execute on your business’ strategy. Additionally, you may want to hand off the task of forecasting and modeling to someone else in your business, and the simpler the model is, the more likely that handoff will succeed. The good news is that if you met the prior 4 criteria for a financial model, you likely have a simple model that’s easy to understand and update. Anyone who understands your business, regardless of their financial and accounting expertise, should be able to understand and use your model.
A financial model can be your north star in running your business because the core of your operations is to create financial results you and your investors will be satisfied with. But a financial model can also be an anchor keeping your company from gaining strategic insights to improve your business. By following these 5 principles to build a great forecast, you will be able to create a financial model that helps you make decisions that generate value for your company.