The easiest part of starting a new business is choosing a name. Even though it may take weeks to find the right name, a good name does not automatically open the doors to unlimited funding and instant success. In order to open those funding doors while piquing the interest of potential investors a visual aid is necessary; this is where a financial model comes in. A financial model for a start-up consists of best and worst case financial statements for a start-up’s future. Yes, financial modeling can seem a bit intimidating and overwhelming, but it is essential to securing needed funding.
It is important that you understand the nature of the business you are embarking upon along with all of the variables inherent to the business in order to build credibility with potential investors. It is even more important that you convey that knowledge and understanding in a cohesive and intelligent manner; a good financial model demonstrates your comprehension of the intended venture.
Step One: Traffic vs. Conversion
The first step in developing your financial analysis is determining the expected amount of traffic and how much of that traffic will convert into customers. There are two ways to do this: the top-down approach and the bottoms-up approach.
The top-down approach takes into consideration targeted variables to reach a likely conversion rate. For example, you are selling children’s clothing in an area consisting of 3 million households. A baseline assumption would estimate that each household consists of one child and that one of every three households will make a purchase within a prescribed time frame, say three months. Factor in additional filters such as competition, market share, etc. This is how you determine traffic; the number of customers expected to visit your business. The next step is to convert that number into expected sales. Since not everyone who visits your business will purchase something you will need to estimate the percentage using industry standards. In the case of the clothing store, it is safe assumption that 0.5% of the traffic will convert into sales.
In essence, the top down approach is based on the assumption that your business can expect to gain a certain market share in year one, and will continue to grow in subsequent years.
The bottoms-up approach takes into consideration how much money is necessary to meet your goals and costs by focusing on actual sales forecasts (potential sales X average transaction value). For instance, a restaurant that has a base operating cost of $5000 per day needs to sell 100 meals at a rate of $50 per meal to cover that day’s operating costs. This is also known as the break-even level: the point where the daily revenue results in zero net profit. Any revenue made beyond this point would be considered profit for the day.
Since it is preferable to be as realistic as possible when developing a financial model, the bottoms-up approach is a better option because is based on fewer assumptions than the top-down approach.
Step Two: Ticket to Sales Conversion
The next step is to establish how you are going to enable conversion and determining the size of ticket sales. Ticket size is the amount generated per average transaction. When the conversion rate is applied to ticket size the resulting number is the sales revenue.
To arrive at a net profit margin, you need to match costs per transaction with ticket size, both fixed and variable. To find the cost, break down the product into individual components. What materials are required to make a single item? What are the materials cost? Determine the points from manufacturing to sales and assign each point a value to cover costs and profit margin.
Investors look for the most realistic probability, so the greater degree of realism in your financial plan the more sincere you appear. Remember to set benchmarks that are achievable in the economy at the time and are consistent with market and industry trends.
Step Three: Tell a Story
All of the financial analysis in the world will not tell the story of your business. An investor can look at the financials and see a certain degree of potential for a start-up but they do not see the vision that you have. Fill in the blanks. Tell potential investors what makes your concept different from others. Explain to them the hook that will draw customers to your doorstep and then show them how you intend to keep customers coming back. Infuse potential investors with your vision and help them understand that you are dedicated to the success of your idea.
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