At Nesta Impact Investments, we look for ventures that have social impact at their core. But – like any investor – we want potential investees to show that their venture is financially sound. Proving both requires a similar aptitude for flexibility and logic.
Creating your first financial model should not be rocket science but a reflection of your money in and out at different points in time.
Financial models are important not only for accounting but to help you plan operational activities in the short-term, forecast for the mid- to long-term, and, most importantly, use as tools that inform management decisions.
For early stage start-ups the focus should be more on monthly cashflows and high level yearly forecasts as there will be plenty of uncertainties still to be pinned down.
1. Make it logical
Avoid the complications of accounting and just think about it in a rational way. Let’s pretend I’m a social enterprise providing training courses for young people to help them access work opportunities. If I assume that I can provide 20 courses a day by promoting them on social media, my business model is as simple as the cost to develop, market and provide the training sessions and the money that I am making out of them.
2. Keep it clean and simple
Make sure you give enough detail of the main levers/drivers of your business, like revenue (price x volume) and costs (cost x volume, salaries, marketing, etc.). Avoid wasting your time detailing things that are hard to predict and would probably not affect your profits much. And don’t take for granted those that have a high level of uncertainty.
To identify the main drivers of your business you need to understand which variables impact on your profit the most, and if you are not sure what they are, the process of creating a financial model will help you to identify these. For example, if you are selling training courses, price and volume might be two variables to investigate. It could be that reducing prices by 15% doesn’t impact revenue as much as selling to 15% less customers, or vice versa. Your model should be able to give you these answers.
3. Allow flexibility and NEVER EVER mix inputs with formulas
Make sure you have a separate tab or another colour on the cells that have numbers that are your assumptions – you want to make sure you can change these. Using the training courses example; don’t simply suppose that you will grow from providing 20 courses a day to providing 200 without any data.
Make it easy to change and adapt it as you start getting more real-life information. Some of the data collected in your model can serve as units of outputs and outcomes that can help predict and map the social impact of your activity.
4. Make sure your model is connected
Make a model that reflects how things might change if you alter certain variables. For example, if you start using additional marketing channels to promote your courses – like university events and career fairs, you want to be able to estimate how many additional customers can come through this new channel and make sure the model reflects this.
This might sound obvious, but from experience, it is amazing how many people forget to link their models correctly to reflect the most important possible changes.
5. Don’t forget the bigger picture
Go back to your logical analysis and, every time you look at each result, ask what it is telling you. You want to avoid just staying at the detail level and start looking for the strategic implications of your numbers. If you are forecasting that you will grow to sell more than 2,000 courses a day, take a reality check – are there 2,000 young people in the community who need this service?
6. Perform some scenario tables or “sensitivities”
As we all know, especially in early stage ventures, things hardly ever go to plan as a lot of your assumptions are unproven. Perform some scenarios to evaluate the impact of changing your main business drivers.
Every business uses different variables to perform scenario analyses, but in most cases you would analyse how price and volume sensitivities have an impact on your profits given a certain set of fixed or variable costs. Sticking with the training provider example, it would be important to know how many courses you’d have to sell to make a profit at a particular price per course, and vice versa.
Once you’ve thought through the different scenarios, you will be able to see the cash impact of the variables, and you may rethink your forecasts to make them more realistic.
So, keep it simple, flexible and logical!
Mireya Alvarez is an investment analyst at Nesta Impact Investments