Taylor Davidson · Financial Models Are Always Wrong: Create One Anyway.

Why is creating a financial model important?
by Taylor Davidson · 13 Jan 2009

Creating a financial model forces an entrepreneur to outline very specifically how a business “works”: how a company creates their products, how users and customers find and use their products and how those processes create revenues and costs. The result, a set of operational metrics, financial statements and the “equation of the business”, is one view of a potential reality of the business. While any one view is inevitably wrong, by digging deeper and analyzing the key drivers and testing a range of assumptions an entrepreneur can create multiple views to help make crucial product design, marketing, organizational and strategy decisions.

Instead of focusing on the bottom line profit and net income, focus on the assumptions and key drivers of the business. Developing a financial model creates the type of thought and data that helps entrepreneurs figure out what they are betting on and how likely their bets will pay off.

What is needed to start creating a financial model?

The best way to start building a financial model is to start thinking about how the business works:

  • What is the business? What is the product / service?
  • How do you target, and acquire customers?
  • What are the revenue streams? (prices, sales of products or services, advertising, usage fees, etc.)
  • What costs will the business create? (items and estimates, employees, hosting, SG&A; fixed costs, variable costs, etc.)
  • What timeline of development and product launch and market / customer adoption are you expecting?
  • What do you think are the major drivers of revenue and costs?
  • What do you know about the market? (# of potential customers, $ spent currently, market trends, growth, competitors, etc.)
  • What lessons, revenue / cost models and performance / operational metrics exist from studying existing competitors and complementary and substitute products?

When I work with entrepreneurs, I typically ask for some preliminary information and data around the above questions, and then after an overview conversation I am able to hack together a first draft of a customized financial model. I typically start with one of two models:

  • Simple Model: A basic one-sheet model that outlines the customer acquisition process, revenues and costs; customized to help an entrepreneur understand the business they are creating.
  • Complete Model: A highly customized, detailed model that creates a full set of financial projections that can be used to raise capital and operate the business.
Want to learn more? Learn how to build financial models or download a financial model template for startups.