What is financial modeling: experts’ explanation

In the conditions of global economic instability, financial planning has become particularly relevant. Companies and startups are faced with the need to demonstrate transparency and a clear structure of their strategies to attract the attention of potential partners. The financial model is based on forecasting key metrics such as revenue, expenses, and profitability, through which an investor forms a long-term vision of the project.

### What is a financial model for an investor and why is it needed?

A financial model for an investor is a tool that allows evaluating the prospects of a project and helping to make an informed decision about investments. The scheme serves as a detailed calculation of all key economic indicators, including not only expected revenues and expenses but also risks that may affect the implementation of investment objectives. The main goals of a financial model for an investor:

1. Forecast future cash flows (revenue, expenses, profit).
2. Evaluate the investment attractiveness of the project through key efficiency indicators (ROI, NPV, IRR).
3. Determine a reasonable rate of return corresponding to the risks of the strategy.

For startups and large companies, such a system is an integral part of the process of attracting external investments. Without proper justification, investments may be perceived as unreasonably risky.

### Key components of a financial model for an investor

Creating a comprehensive plan requires careful analysis and inclusion of all key elements that can affect future results:

1. **Revenue and expense forecasting**: basic data for understanding the financial position of the project throughout its implementation period. Short-term and long-term effects should be taken into account, including seasonal fluctuations and changes in the market situation.

2. **Key performance indicators (KPI)**: include metrics such as NPV (net present value), IRR (internal rate of return), ROI (return on investment). Based on these parameters, an investor determines how profitable the product will be and to what extent the risks are justified.

3. **Forecasting and rate of return**: assessing what benchmark should be applied to discount future cash flows.

Startup HealthTech Solutions from the UK, founded in 2020, developed a platform for remote monitoring of patients with chronic diseases. The revenue forecast was 20% annually, exceeding the average market indicator by 5%, thanks to stable demand in the digital healthcare sector. The NPV discount rate was set at 12%, taking into account moderate economic risks.

Raising £2 million in investments enabled product scaling and entry into the European market. A key aspect in creating a financial model for an investor is to correctly link all components together to create a clear picture of the current state of development and its prospects.

### How to forecast revenues and expenses correctly?

Forecasting revenues and expenses is one of the most critical stages of creating a financial model for an investor. Errors at this stage can lead to serious consequences, such as incorrect decisions on the size of investments or the acceptable level of risks. Forecasts should take into account several important factors:

1. **Seasonality and market fluctuations**: expected revenues may depend on seasonal changes, for example, in agriculture or retail. It is important to consider how fluctuations in demand for products or services can affect profits.

2. **Variable and fixed costs**: expense forecasting includes not only fixed costs such as rent or staff salaries but also variable costs that may vary depending on sales volume. These data must be as accurate as possible to avoid distortions in calculations.

3. **Inflation and economic situation impact**: factors such as inflation or changes in tax legislation should also be considered in forecasts. Price increases for raw materials or interest rate hikes can significantly affect overall costs.

### Evaluation of an investment project: how to assess risks and potential profitability?

Assessing risks and potential profitability is an equally important stage in forming a financial model for an investor, where potential problems can be identified in advance and prepared for. What to pay attention to:

1. **Revenue and profitability forecast**: all calculations should be based on realistic market data, competitors, and economic conditions. Revenue assessment is based on market research, competitor analysis, and analysis of external factors such as legislative or policy changes.

2. **Assessment of macroeconomic risks**: it is important to consider external influencing factors such as fluctuations in exchange rates, changes in tax policy, as well as forecasts of overall economic growth or decline.

3. **Risk modeling**: various methods can be used for assessment, such as scenario analysis or sensitivity analysis.

Startup GreenWaterTech from Germany, founded in 2019, developed innovative water purification equipment using membrane technologies. The financial model included a revenue forecast of €2 million in the first year, with an annual growth of 15%. The scheme considered variable production costs (€800 thousand) and marketing costs (€300 thousand). System testing revealed a stable profitability of 25% annually. Investors invested €1.5 million, confident in the product’s potential and the transparency of the calculations.

Key indicators for assessing the risk of an investor’s financial model are IRR, which allows determining the attractiveness of an investment considering all factors, and NPV, demonstrating how profitable the project is in the long term.

### How to create a financial model for a startup: step-by-step guide

The process is not much different from classical modeling. Steps:

1. **Collecting initial data**: at the start, it is necessary to gather all data about the project, including information on expected revenues, expenses, capital, and other resources. It is important to have data on the market, competitors, and risks that may affect the development’s success.

2. **Forecasting revenues and expenses**: based on the collected data, analytics for several years ahead is built. It is important to make this forecast as realistic as possible, considering possible market fluctuations and external factors.

3. **Assessing key efficiency indicators**: after making forecasts, it is necessary to calculate metrics such as NPV, IRR, and ROI. These data will help the investor understand how profitable the startup will be in the long term.

4. **Model testing**: the scheme needs to be tested on various scenarios to understand how it will behave in case of changes in market conditions or other external factors.

### Conclusion

To make a financial model for an investor as attractive as possible, developers gather and analyze accurate data, supporting them with real research and objective facts. This approach minimizes risks and increases trust from capital holders. Each planning element demonstrates a high degree of transparency and justification, ensuring its reliability and investment attractiveness.

Financial modeling is a key tool for analyzing and forecasting company activities. It is necessary for managing resources, evaluating investment opportunities, and planning for growth. In modern business, using various types of financial models allows for making informed decisions at all levels of management. Each form has its own characteristics, tasks, and areas of application.

### Three-Statement Model: Foundation for Comprehensive Analysis

The three-statement model is a classic and versatile type of financial forecasting used to assess the current state of a business and build long-term perspectives. The scheme is based on three main documents: the income statement (P&L), the balance sheet, and the cash flow statement. This form is the foundation for most financial analyses.

Components:

1. **Income Statement (P&L)** reflects the company’s economic results for a specific period. It shows revenues, expenses, and net profit, allowing an understanding of how effectively the organization manages its resources. For example, analyzing the profit margin helps determine the profitability of the business compared to competitors.

2. **Balance Sheet** demonstrates the current financial position of the firm, including assets, liabilities, and equity. It helps determine how the company utilizes resources and its ability to cover obligations. For Russian businesses, the balance sheet is also important for compliance with legislation, such as preparing reports for tax authorities.

3. **Cash Flow Statement** analyzes the inflow and outflow of cash over a specific period. It provides an overview of the company’s liquidity and its ability to finance its operations.

### Investment Model: Risk and Return Analysis

The investment financial model is designed to evaluate the viability of a specific project or company in terms of capital investment. It is used by both investors and internal organizational units to justify decisions on large investments.

Key components:

1. **Discounted Cash Flow (DCF) Valuation**. The discounted cash flow method calculates the present value of future project-generated income. This is particularly important for long-term plans, where factors such as inflation and default risk need to be considered.

2. **Internal Rate of Return (IRR)**. This metric helps determine the profitability of a project. For example, if the IRR exceeds the cost of capital, the program is considered viable. In Russia, this parameter is important for evaluating infrastructure or production projects requiring significant investments.

3. **Net Present Value (NPV)**. NPV reflects how much an investment exceeds costs, considering discounting. If the value is positive, the project is profitable.

### Scaling Model: Growth Planning

Organizations planning to expand their operations use the third type of financial model. The scheme allows for assessing the economic needs necessary for growth and the potential profit from scaling. This tool is particularly relevant for companies in the active development stage.

Key elements:

1. **Assessment of Additional Costs**. When scaling a business, it is important to consider the additional expenses that will be incurred. For example, expanding production will require equipment purchases, hiring staff, and increased marketing expenses.

2. **Revenue Growth Forecast**. This type of financial model helps determine how much the company’s revenue will increase with expansion. For example, in retail, this could be an increase in sales through opening new outlets.

3. **Scalability Profitability**. It is important to understand how increasing the scale of the business will affect the overall profitability of the firm. If cost growth exceeds revenue growth, expansion may not be feasible.

### How to Choose the Right Type of Financial Model?

Choosing the correct type of financial model is a crucial step that determines the success of strategic planning and resource management for a company.

#### Goal Assessment

Business objectives determine which type of modeling will be most effective. If the goal is to evaluate current financial indicators and manage liquidity, the optimal choice is the three-statement model. It provides a complete picture of the company’s status and allows tracking key metrics: profitability, debt, and cash flows.

When it comes to the need for capital attraction, such as through venture investments or bank financing, the best solution is the investment model. It helps justify the project to potential investors or creditors, demonstrating their benefits and minimizing risks. For startups and companies aiming for rapid growth, the scaling model allows for analyzing the financial resources required to achieve ambitious goals and how it will impact profitability.

#### Considering the Company’s Development Stage

Each stage of a business’s life cycle requires the application of a specific type of financial model. During the startup phase, when assessing market opportunities and long-term potential is crucial, the investment type is most commonly used. It enables calculating the return on investment and forecasting growth prospects.

Organizations that have transitioned to a stage of stable operation use the three-statement model to analyze current activities and manage operational costs. During the expansion phase, when a company actively increases its market share, scaling becomes indispensable.

#### Dependence on the Industry for Choosing the Financial Model Type

The characteristics of the sector in which a firm operates play a significant role. For example, construction companies often use investment models to evaluate large projects. Forecasts include a detailed analysis of costs, payback periods, and profitability prospects.

### Conclusion

A financial model is not just a type of calculation scheme but a powerful tool for management and planning. Each type of forecasting performs unique functions and helps solve specific tasks. Using these tools allows companies to make more informed decisions, efficiently manage resources, and attract investments.