Running your business online is no easy task. From raising funds, managing finances, tracking leads all the way to valuing your inventory, there’s no end to how time-consuming all of it can get.
Let’s lighten that burden for you with a proper re-education on financial modeling, from the ground up. Here we’ll walk you through one of the most essential things any e-commerce business needs:
A financial model.
It doesn’t matter whether you’re a stay-at-home parent running an online cookie store or a designer selling your own line of clothing on Amazon, a well-thought-out financial model will make your business perform infinitely better.
So, what exactly is financial modeling?
In a nutshell,
“ Financial Modelling is a form of forecasting. It’s a data-backed estimation of how well your online business will perform in the future so that you can plan accordingly”
For example: Let’s say you own an online store on Shopify. A financial model helps you project your future sales, based on your performance so far. You can accordingly decide what changes you should make in order to get closer to your business goals.
How does it work?
Financial models are created using simple spreadsheet software. Every aspect of your business that matters: funds, sales, capital, customers, profit, staff, and everything else becomes a variable. That’s how it’s represented in the model.
This helps you visualize the likely outcomes that result from shifting any of these variables.
“A financial model is essentially taking an aerial view of your business. It helps you see the big picture and spot trends to know how well your business is performing.”
Why do you need financial modeling for your online business?
- Manage expectations:
A financial model helps you predict how well your business will perform in the future based on how it has already performed in the past.
However, a financial model is not just about predicting how your business will perform based on underlying assumptions.
It also helps you visualize how your business can grow if you changed those assumptions.
In other words, it plays a pivotal role in decision-making for the future.
1. Track Growth:
You can get a fair idea of how far your business has come, set goals, and decide how much further it can grow in the future. This is how you make sure you’re turning your vision into an economically viable business.
2. Metrics to Measure:
A proper financial model values your business in concrete terms. You’ll be using figures, numbers, charts, and other helpful visual aids to actually validate whether your business is economically viable.
3. Prepares you for challenges
A financial model isn’t meant to charge you up with unjustified optimism. Rather it gives you a realistic picture of your business. Not only will you be planning for the best, you will also be using it to prepare for the worst.
4. Budgeting and forecasting.
Forecasting is the primary function of any effective financial model. By looking at your entire business as one cohesive whole, you’re able to make informed decisions on how to allocate your budget to reach your performance goals.
5. Valuation to Grow your business, through funding
A financial model goes a long way in helping you actualize your business growth aspirations. It helps you convince potential shareholders to invest in your idea.
Figures and growth projections are way more persuasive to investors than saying “there’s a big market for this” with nothing to back it up.
6. Deciding your future operational needs:
Ideally, a financial model helps you spot areas of your business that are lacking and decide how much you need to focus on them.
Eg: what time would be best to run an ad campaign, how much should your ad spend be, etc.
7. Understanding your future goals:
You’ll have a good grasp on things such as how high your sales need to be for you to surpass the break-even point.
8. Estimating your future expenses
A decent financial model helps you reasonably anticipate future expenses that arise as your business grows.
Key Essentials of a Financial Model
These are the Income, or Profit and Loss (“P&L”) Statement, the Balance Sheet, and the Cashflow Statement. Later on, you will learn how they are all reliant on each other and how crucial they are crucial in helping you forecast future performance.
Assumptions take the form of any data that substantiates your business numbers. For eg: market research, site visitors, past sales, etc.
“Assumptions are the driving forces behind changes that appear in estimated financial statements. In other words, every likely outcome reflected in your projected statements, be it profit or loss, is based on reasonable assumptions.”
These include capital assets such as inventory, machinery, premises, equipment, etc. minus the depreciation accumulated by each.
Alongside capital schedules, you also need to include any increases in debt from the past period, minus repayments.
Sensitivity analysis is basically running your model through several hypothetical scenarios to see how your business will be impacted.
As mentioned earlier, you’d be able to visualize how your business performs when you change certain assumptions.
This will in turn aid you in making important decisions for the future of your business.
The most basic financial model
Three Statement model:
The most basic financial model uses the 3 financial statements we mentioned earlier:
Income Statement, Balance Sheet, and Cashflow. As mentioned earlier they are the outcome of various accounting principles and based on a set of assumptions, you also get to observe how these three variables interact with each other, affecting the business as a whole.
What does each key financial statement show?
Income Statement or P&L Statement:
The Income Statement or P&L gives you a snapshot of how well your business is performing in terms of Revenue (sales), Cost of Goods Sold (COGS), Expenses and profit. It also provides the data needed to calculate key metrics like Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA).
Most importantly, it helps you compare Performance in different time periods and also your
budget vs actual performance.
EBITDA: This is a highly useful metric that is often used as a proxy to Free Cash Flow that gives potential investors an idea of how efficient your business operations are.
The Balance Sheet lists out all the tangible assets you own, such as Plant, Property, and Equipment, Working Capital such as raw materials, or inventory computers, stock, and premises (If any) as opposed to the liabilities you owe over a period of time.
The difference between assets and liabilities represents shareholders equity
This statement shows all cash going in and out of the business over a period of time. These include:
- Operational cash flow: Cash generated by normal business activities.
- Investing cash flow: Cash coming in or going out of your business as a result of long-term investments.
- Financing cash flow: Cash flow from debt, equity, and dividends.
Other common financial models
This model is used to find out your business’s present value by using estimated future projections of free cash flows. The current value arrived at is called “net present value”
This is a model that determines the value of a business as well as the returns expected in a period of 3-5 years. This is because it is commonly used when a private firm buys a company using a mix of cash and debt with the intention of selling it after a period of time.
M & A
The merger and acquisition model is used to help shareholders see the effect of acquiring a business. It shows what the Earnings Per Share (EPS) post-acquisition would like compared to existing Earnings.
How to build a basic financial model?
1.Gather all your historical data and set assumptions
Your financial model begins with a complete look at past data of how your business has performed up until now. These will be represented in the financial statements.
Input all this data into a spreadsheet. Now you’re ready to set assumptions for the future based on the data you have.
(Historical data : revenue growth rate, gross margins, variable costs, fixed costs, AP days, inventory days)
2. Begin with the income statement
Once you’ve set assumptions, you need to compute your income from top to bottom. This will include revenue, COGS, Gross Profit, operating expenses, and EBITDA.
3. Move on to the balance sheet.
Once the income statement is done, proceed to fill in the balance sheet with assets and liabilities.
4. Use supporting schedules
Factor in capital assets and debts you’ve yet to receive into your balance sheet and income statement.
5. Add the cash flow statement
Prepare a statement of all the cash that has come in and gone out of the business (inflow and outflow) over the fixed period. This includes cash from operational activities, financing, and investment.
6. Perform Sensitivity tests
You are now free to test your model and determine likely outcomes. Change indicators present in the current valuation of your business to see how the performance of your business can be affected.
In short, if you aim to make your e-commerce business more sustainable, you definitely have to consider building financial models and testing outcomes so that you can discover new ways to make your business grow.