Building a Forecast Model
Developing a financial model is one of the most dreaded activities for many entrepreneurs. And, hiring a financial professional to do it for you may not be financially possible. So many entrepreneurs just start with a basic presentation page and plug in some numbers based on their best guess.
The problem with this approach is that it becomes very difficult to tell the story on how you arrived at those figures. Investors will know if you really understand your business financial drivers.
The goal of the forecast model is to show that you have a handle on the factors that will directly impact the success or failure of your company. Most investors won’t care if your projections prove wrong. What they care most about are the assumptions you’ve make about how you’re going to grow your revenue and what is going to impact your costs, and that you’ve put a lot of thought into this.
Before you begin building your model, you should have a base understanding of basic accounting and financial terms. We have compiled a list of theFinancial Terms Every Entrepreneur Should Know as a reference. There are three statements most investors will want to see – Income Statement (or Profit and Loss), Balance Sheet and Cash Flow. Initially, entrepreneurs should start with the Income Statement and a basic Cash Flow model.
Cash vs. Accrual
You may have heard the terms “cash” and “accrual” used to describe financial statements. This is an important concept to understand as many investors will request to see your statements using the GAAP-approved accrual basis. The cash method is mostly used by small businesses and for personal finances. The cash method accounts for revenue only when the money is received and for expenses only when the money is paid out. The accrual method accounts for revenue when it is earned and expenses goods and services when they are incurred. The revenue is recorded even if cash has not been received or if expenses have been incurred but no cash has been paid. Accrual accounting is the most common method used by businesses. To develop a sound financial model, you will need to understand how your cash in and out aligns with the recognized, or accrued, revenue and expenses.
Where to Begin?
You financial forecast should begin with understanding the most important drivers or levers of each aspect of your business – both from a revenue and expense standpoint. Every business will be different – for some businesses it is website conversion, for others it might be current client expansions. On the expense side, you will want to identify all of your expense categories and the assumptions behind each one – maybe your expenses are tied to your revenue, or they may be variable depending on the number of employees, or perhaps they are fixed regardless of other factors.
Identifying these drivers and the assumptions behind them are important for three reasons:
- They allow you to do what-if and sensitivity analysis
- It forces you to really think through what the drivers are for all aspects of your business
- It shows outside parties/investors you understand what it will take to achieve your goals
Building the Model
Building the model will require some Excel proficiency (or find a high school or college student to help you!). We’ve provided a very basic Recurring Revenue Forecast Model as a starting point for you. Here is how we like to approach it. The key when first staring is to keep it simple!
- Start with one tab for assumptions
- Create a separate tab for each year income statement (typically 5 years), the rows on your Income statement should match your Chart of Accounts (list of revenue and expense categories in your accounting system)
- Create one tab that summarizes all 5 years
- Create one tab for headcount/salaries
- Create one tab for revenue
- Create one tab for expenses
- Have a separate tab for graphs
Initially, there is no need to forecast a balance sheet – cash balance & investment expectations are good enough to start with
Your work does not stop once you have your financial forecast. You will want to keep refreshing and reevaluating the forecast. At the end of each month, pull in your actual results and evaluate how you did against your original forecast. Were your assumptions correct – do you need to adjust them or add any new assumptions?
For reference, included is a presentation that summarizes the information and activities necessary to Build a Forecast Model.