The Purpose of Financial Models
The Purpose of Financial Models
Adam Tzagournis, CPA · Founder & CEO · 4 min read
A financial model is a tool that helps you predict your company’s future performance. It takes your assumptions and converts them into projections for revenue, expenses, and cash. There are two main purpose to this exercise:
Get ongoing, actionable insight to improve your business
Create projections required for board meetings and raising money from investors
In order for a financial model’s results to be meaningful though, it’s not enough to mandate the outcomes directly. Simply stating that revenue will grow by 25% next year doesn’t mean much if you can’t show how you arrived there. Forecasts must stem from key business drivers.
From an operations standpoint, models help you better understand your business in a few important ways.
Don't run out of cash
Cash is king, and predicting the timing of cash flows is never easy. Financial models try to approximate it so you know in advance if/when you’ll run out of money. Many factors can influence this timing, and some of the major ones for SaaS companies are:
Contract terms of your product (average contract value, upfront payments, recurring payments, setup fees, etc)
How long it takes to collect money from your customers
Extent of revenue growth (driven over time by evolving marketing and sales efforts to win new customers)
The timing of payroll, rent, marketing spend, and other expenses
Financial models will also help you understand the fundamental dynamics of your company. For instance, the unit economics for SaaS companies depend on your LTV : CAC ratio (lifetime value of a customer compared to customer acquisition cost). This ratio uses the company’s churn rate as well as the gross margin earned on an average contract; it then compares the result to marketing spend related to acquiring new customers. In other words, the result is a measure of how profitable the average customer is relative to the amount “invested” to acquire that customer.
It’s usually the case that just a handful of levers in your business determine its performance (the Pareto Principle or 80/20 analysis). Sensitivity analysis is the process by which you can identify those levers; it’s the practice of changing an input in a system to see how much the output changes. Often times, it reveals the factors that are most important and impactful for driving a desired outcome. For example, sensitivity analysis can show how various levels of marketing and sales efficiency affect revenue. A deep dive into these dynamics would incorporate the following inputs:
The time it takes for a lead to go from marketing qualified all the way to an onboarded customer (and the conversion rates along the way)
Changing amounts of marketing spend over time
Increased sales team efficiency for winning new business
More efficient outbound sales efforts over time for generating new leads
This type of sensitivity analysis can pinpoint the most critical constraints limiting your growth. For instance, investing additional time and money to generate quality leads may not move the needle if the sales team is very inefficient at closing deals. Instead, that time and money is better spent on improving systems and processes to help sales reps close more deals. Financial models, when well-built, can reveal these 80/20 insights.
Progress updates for your board require projections based on the strategy in place for growing your business over the next 12 – 18 months. Financial models support your growth story by specifying how key business drivers will change in accordance with actions from your operating plan.
Aside from pitch meetings and back-and-forth with potential investors, the diligence phase can make for a particularly strenuous fundraising process. Often, investors will dig for further explanation of projections summarized in your pitch deck. Here is where a robust model proves its value:
Similar to board meetings, short-term forecasts help explain how your efforts over the next 12 months will move the company forward, in conjunction with your strategy and product roadmap.
Long-term projections give investors a sense of your company’s true potential.