Troy Henikoff’s Step-by-Step Approach to Financial Modeling

Excelerate programming in July is limited to what we like to call the “Entrepreneurs’ MBA.” During this time, we bring in experts in their respective fields to discuss all the topics that entrepreneurs need to know, but is knowledge they won’t get anywhere else.

To kick off this programming, our very own Troy Henikoff spoke to the teams on the process of creating a financial model. Troy’s motto of “what gets measured, gets done” is applicable to all aspects of a business, but is most apparent when applied to finances.

1. Step number one is to realize you are building a financial model, not just financial projections. Understanding the difference is key. Projections are estimates of future facts and figures; models are numbers that actually demonstrate how your business responds to changing variables. The goal of this model is to give you a dynamic spreadsheet where you can change one input variable and see how it will change all of the other outputs. Models need to be dynamic and responsive.

2. When it comes to building your model, your first sheet should always be a set of assumptions. These assumptions should be collected from past industry averages, competitors’ annual reports, or, best of all, past experience from your own business.

3. From here, you should be sure to include the most important financial statements: income statement (revenues and expenses), balance sheet (assets and liabilities), and a statement of cash flows (actual cash transferred in and out of your business). Again, these need to be responsive to changes in your assumptions. This is crucial.

4. Once your model is “done,” spend some serious time with it. Understand the ins and the outs of any adjustments you may make. If you change one input assumption, make sure you know how it will affect the outputs. Knowing your model well shows that you know your business well. This will be clear to potential investors when they do their due diligence.

5. Finally, when it comes down to sharing your model, be realistic about it. Make sure you tell your investors that you know your projections are going to be wrong. This doesn’t mean your model is wrong. There is zero chance that the number you estimate as your revenue in year one is actually going to be your revenue in year one. Investors know this; you should know this, too. What matters is the sensitivity of the key metrics in your financial model, and this is what you should focus on.

A good financial model is necessary for a good business. Not only does it show you understand your business, but it also shows that you are dynamic enough to adapt to changes in market conditions. When investors look at your business, they will also be looking to see that you are a clear and logical thinker. Working through a well-built financial model is a great way to demonstrate this and share your business with quality investors.

Filed under: Status Updates — Tags: , — July 12, 2012