Most entrepreneurs fall in love with an idea and spend a lot of time building out what it looks like. For example, a software developer will work on the features of his software product; a chef will work on the menu for her restaurant; and a service provider will identify potential customers for her services.
This is the fun part of creating your business plan, and it is absolutely essential. But what I have noticed is that a lot of entrepreneurs get caught up in the features of their business product and begin designing their office space and expansion plans before they sit down to build a financial model for their business.
What is a Financial Model?
A financial model, or a financial plan, is basically an Excel document into which you can plug various factors that will impact your financial future as an entrepreneur.
For example, the software entrepreneur needs to sketch out pricing packages and then model what will happen if 10, 100, and 1,000 people start using her software. For example, if she gets 100 people to pay for her software, at $100 each, she will make $100,000. But in addition to this “happy number,” she also needs her model to tie in how much it will cost her to acquire each customer and how each paying user of her product will impact her costs.
Setting Up Your Financial Model Worksheets
Typically your financial model Excel document will have multiple worksheets to account for various factors. Most financial models should include the following four worksheets:
Customer Acquisition: based on your marketing plan, you need to estimate both prospective customers and sold customers. Consider:
|How many prospective customers do you need to reach in order to acquire a single paying customer?||There are some industry averages out there, but a good rule of thumb is that you will convert 2-3% of prospects.|
|How many paying customers can you anticipate based on your marketing plan?||If you reach 1,000 people with a targeted marketing campaign, and your conversion rate is 2%, you will acquire 20 customers.|
|How much will it cost you to reach the right number of prospective customers in order to convert the total number of paying customers that you need?||The targeted marketing campaign includes costs for graphic design ($45), printing ($250), and distribution ($595). So your total campaign will cost $890.|
|What is your cost per “sold” customer?||Your marketing cost was $890 to convert 20 customers, so your cost per “sold” customer is $45.|
Revenue: based on your customer acquisition model, you can estimate revenue. Consider:
|What is your monthly revenue per revenue stream? The more detailed this section of your financial model, the better. You may have the following types of revenue streams:
||For example, one revenue stream could be the marketing campaign detailed above. You may estimate that, of the 200 customers converted in the campaign, 10% (20) go with the highest level ($100); 75% (150) go with the middle level ($75); and 15% (30) go with the lowest level ($50). Thus, the revenue would be $2,000 + $11,250 + $1,500 = $14,750.|
|What is your total revenue per month?||This is where you would add up all of your revenue streams.|
Fixed Costs: your fixed costs are the expenses that your business has to carry just to “keep the lights on.” Consider:
|What are your monthly costs per month? The more detailed this section of your financial model, the better. The major fixed costs to consider are:
||Depending on your industry, you may also have specialized fixed costs. For example, a software company may have significant server and maintenance costs that could fall into the fixed cost category.|
Variable Costs: your variable costs are the expenses that vary based on the number of customers you serve. Consider:
|What are your variable costs each month?
||Be as specific as possible, but in the planning stages you might need to estimate an average percentage of revenue. For example, a restaurant can estimate that in a $10 sale, $3 will go to food costs and $0.15 in credit card processing fees.|
Profit & Loss: Once you have the four worksheets above, you are ready to build your profit and loss (P&L) worksheet (also called an Income Statement). This will bring all of your information together so that you can see how your income and expenses compare and, ultimately, when you can expect to see a profit from your business.
For resources on the elements of a profit & loss statement, check out this template available from Entrepreneur Magazine.
Your Financial Model in Action
If you have set your financial model up as a linked workbook in Excel, then you will have the opportunity to play with your numbers. For example, you can create “worst case,” “average,” and “best case” scenarios to help you determine the risk level walking into an opportunity.
But don’t abandon your financial model once you dive in and launch your business! Your financial model should be a living, breathing document that you reference regularly to make sure you are on the right track. Over time, you will learn which numbers in your business are “indicator numbers” that tell you quickly whether you are on the right path.
Vukani Nxumalo says
By far the most detailed financial model building method I have. Every business person that seeks to be successful as small business owner or an entrepreneur needs to understand how they make their money. Otherwise with all the passion and enthusiasm, your work becomes nothing more than just an expansive HOBBY. Thanks Virginia, Great article. This is a definite ‘must share’
Virginia Ginsburg says
Thanks so much for your comment, Vukani! I appreciate your thoughtful response.