Building a Financial Model

Building a Financial Model

Introduction

Your Financial Model is among the most important documents you’ll need to maintain (and sometimes share). When we talk about financial models, you’ll sometimes hear the term “3-sheet model”. This refers to the fact that the financial model is composed of three separate but interconnected views of the organization: the Profit & Loss Statement, the Cash Flow Statement, and the Balance Sheet.

You will likely want to build your forecast/model with a 3-year monthly projection. In some cases the projections will be quarterly rather than monthly, and in some cases there will be a 2-year projection rather than three.

You’ll build your model in Microsoft Excel or Google Sheets. There are other model-building tools out there, for example Causal. These often require a learning curve, whereas most people are already familiar with traditional spreadsheets.

Profit & Loss Statement

This is interchangeably referred to as “P&L”, or “Income Statement”. In a very basic sense, The P&L tells the reader whether the company is making or losing money on an ongoing basis. This is different from cash flow, which we’ll talk about in the next paragraph. The P&L shows the net profitability of the company at a point in time. There will usually be differences between the profitability and the amount of cash actually coming in/going out; the differences are detailed in the Cash Flow Statement.

You will begin building your 3-sheet model with the P&L. The P&L builds up the company’s profitability, starting with a calculation of revenues, then layering in several different types of costs, and ultimately subtracting the costs from the revenues to calculate profits. The basic structure of the P&L is as follows:

Notes:

• In most cases, you will be projecting – and reporting – Operating Income.
• Convention: "+" for increases and "-" for decreases in the corresponding line items.

Cash Flow Statement

The Statement of Cash Flows “trues up” the Income Statement (P&L) to account for timing differences related to actual cash coming in and going out. For example, revenue will usually be “booked” to the income statement when the invoice is generated, but the actual cash may not show up in the bank account until 30 days later, depending on the contract terms (and customer compliance). The Statement of Cash Flows keeps track of details like this and shows how much the total cash balance either grew or contracted.

A generalized Cash Flow Statement is below:

Notes:

• Net Increase (Decrease) in Cash and Cash Equivalents = sum of Net Cash from Operating, Investing, and Financing)
• Convention: "+" for increases and "-" for decreases in the corresponding line items.
• It should be noted that for early-stage companies, “Cash and Cash Equivalents” is often (if not usually) simply the sum of bank balances.
• The Net Increase (Decrease) in Cash and Cash Equivalents is added to (subtracted from) the previous period’s Cash and Cash Equivalents to get the current period’s Cash and Cash Equivalents:
• Cash and Cash Equivalents at Beginning of Period

+ Net Increase (Decrease) in Cash and Cash Equivalents

= Cash and Cash Equivalents at End of Period

Balance Sheet

The Balance Sheet provides a point-in-time view of what the company owns, what it owes, and how much the owners’ share is. The overriding rule for the Balance Sheet is that Total Assets must equal Total Liabilities + Owners’ Equity.

The Balance Sheet gives a detailed view of each of these components. Most Balance Sheets will include a “check” formula that ensures that the Balance Sheet “balances”, which means that Total Assets do indeed equal Total Liabilities plus Owners’ Equity.

A typical Balance Sheet is structured as follows:

Notes:

Total Liabilities and Equity (= sum of Total Liabilities and Total Equity)

Total Assets - (Total Liabilities + Total Equity) = 0

Software-as-a-Service (SaaS) Business Models

SaaS companies are really no different from any other business in terms of the basics of the three-statement model. However, there are several distinguishing features of a subscription-based business model that influence how you build your model.

Revenue Modeling

The main difference from a modeling standpoint is how you get to the revenue line. Typically, there is at least one supplementary tab in your spreadsheet exclusively dedicated to calculating the ultimate revenue number per period, starting with calculating the number of customers per period.

In SaaS, the basic model is:

Customers at Beginning of Period

• New Customers from Sales Efforts
• New Customers from Marketing Efforts
• New Customers from Other Sources (e.g., word-of-mouth)
• “Customer Churn” (unsubscriptions)

Customers at End of Period

This customer number is then multiplied by price to get revenue. Of course, the reality of your model will be more complex than this: you will likely have price tiers, or even individually-negotiated contracts. Ultimately, though, you should build your revenue model from the “ground up”, meaning starting with the number of customers/clients.

Of course, this is a very simplified example; models get significantly more complex, accounting for tiered subscription pricing models (as discussed above), upsell, downsell, reactivations, etc. We will treat the complexities of churn in slightly more detail in the section on SaaS-specific Metrics.

Our recommendation is your model be as simple as it can be while still capturing the essence of how your revenue is actually generated.

Costs

Cost of Good Sold (COGS)

Software as a Service companies by their nature rely heavily on software, platforms, and systems provided by other vendors. These costs are considered Costs of Goods Sold. Most SaaS companies aim for and expect to have relatively low COGS in relation to revenue.

Operating Expenses (OpEx)

As outline above in the section on Profit & Loss Statement, there are three main components of Operating Expense:

Sales & Marketing Expenses

Sales & Marketing Expenses are pivotal for SaaS companies, as they directly influence the crucial metric of Customer Acquisition Costs (CAC). These expenses encompass various components, from basic per-customer assumptions to more intricate models incorporating detailed line-item expenses and headcount calculations.

By dissecting and analyzing Sales & Marketing Expenses, companies gain valuable insights into their CAC metrics, moving beyond mere assumptions to make informed decisions that drive efficient customer acquisition strategies and optimize overall business performance.

Research & Development Expenses

Research and Development (R&D) Expenses represent the investment made in advancing product development, a particularly significant aspect for Software as a Service (SaaS) companies. These expenses typically constitute a substantial portion of revenue, reflecting the company's commitment to innovation and staying competitive in a rapidly evolving market. While engineering salaries form a significant part of R&D expenses, they also encompass various direct investments aimed at enhancing product features, functionality, and performance.

This proactive investment in R&D underscores the company's dedication to continuous improvement and meeting the evolving needs of its customers, positioning it for long-term growth and success in the dynamic SaaS landscape.

General & Administrative Expenses

General and administrative expenses (G&A) cover essential operational costs not directly related to production. These include salaries, office supplies, utilities, and professional services like legal and accounting.

Managing G&A efficiently is crucial for financial health, involving measures like streamlining processes and negotiating cost-saving contracts, ultimately allowing for more resources to be allocated toward strategic growth.

SaaS-Specific Metrics

There are many “standard” business metrics you can develop as part of your model/dashboard, and there are many lists available on the internet.

In addition to “normal” business metrics, there are also many SaaS-specific metrics, and many lists of those are also available on the internet.

Unit Metrics are one subset of metrics that apply broadly, but get particular attention in SaaS businesses. Unit Metrics boils down to “what if we focus on one user”? So looking at the revenue per user, the total cost per user, and several other standard metrics all fall under Unit Costs. Many good financial models will include a separate tab for Unit Metrics. These separate tabs can become very detailed, as they can detail very specifically how the business makes money on a per-customer basis.

We provide a short list of the most common SaaS metrics that should be included somewhere in an output tab in your 3-sheet model. Again, we encourage the reader to do their own research to add to (or subtract from) this list as appropriate to their own specific business model:

• Annual Recurring Revenue (ARR): This measures how much revenue is “locked in” for a year (or more). Most good models will estimate ARR as 12 x Monthly Revenue, and although this is only an estimate, it suffices for most purposes.
• Average Revenue Per User (ARPU): Simply Revenue divided by total number of end users. In more sophisticated models, ARPU may be broken out and separately calculated for each segment or tier of end users.
• Customer Acquisition Cost (CAC): This is the sum of all marketing and sales-related costs that can be directly attributed to generating customers. CAC is usually presented on a per-user basis, so divide that sum by the total number of end users. In more sophisticated models, CAC may be broken out and separately calculated for each segment or tier of end users.
• Lifetime Value (LTV): This is the Net Present Value (NPV) of an End User’s Net Cash Flows. Essentially, it is Revenues per End User - Customer Acquisition Costs per End User, summed over time, and discounted by an assumed percentage rate. There is good information online about basic NPV calculations, or more advanced LTV calculations for those already familiar with NPV.
• Retention/Churn: Retention is the percentage of the customer base that the company keeps over a given period of time. Churn is the opposite: it is the percent of the customer base that the company loses over a given period of time. Since one is the inverse of the other, we’ll only talk about Retention. It’s important to distinguish between Net Retention and Gross Retention.
• Gross Retention measures the percentage of customers retained over a given period, typically month-over-month or year-over-year. It represents the total number of customers who continue to subscribe to a service without accounting for any changes in their spending on the product. In essence, gross retention provides a baseline understanding of how effectively a SaaS company is retaining its customer base.
• Net Retention factors in not only the customers retained but also the expansion or contraction of existing customer accounts during the same period. It considers revenue generated from upsells, cross-sells, upgrades, or additional purchases made by existing customers, as well as any revenue lost due to downgrades or churn. Net retention provides a more comprehensive view of customer retention by incorporating the revenue impact of customer growth or contraction.

Templates vs. “From Scratch”

As with lists of business metrics, there are innumerable templates available for download on the internet. Some of them are free; others can cost hundreds of dollars. In our experience, templates are rarely – if ever – as simple to deploy as their authors purport. There is always customization required, and that customization often involves a fair amount of Excel editing. Of course, you don’t have to use a template. You can build your model from scratch.

Starting from scratch can be as simple as copy-pasting the above P&L, Balance Sheet, and Income Statement into Excel, adding a timescale along the top row, and then methodically adding the details required. Or starting from a fresh download from your accounting system. (This option, if done properly, requires that your accounting “books” are properly structured. If they are, then a download from them will look very similar to the statement skeletons provided above.)

It is your choice whether you use a template or build your model from scratch. For your convenience, though, we have found one particular “roundup” article on SaaS templates that we liked.

Recommended Templates

For your convenience, we are summarizing the list of “best” SaaS model templates here:

1. Fisy Innovation Plan, by Rémi Berthier
2. SaaS Financial Plan 2.0, by Christoph Janz
3. SaaS Financial Model 3.0, by Baremetrics
4. SaaS Financial Plan for Startups and SMBs, by Ben Murray
5. SaaS Startup Kit, by Pro Forma
6. "SaaS Financial Model" by Taylor Davidson*
7. "SaaS: SME & Users" by Alexander Jarvis
8. "SaaS: Enterprise, SME & Users" by Alexander Jarvis*
9. EY Finance Navigator, by Alex and Wout
10. Liveplan, by Palo Alto Software*
11. Summit, by Matt Wensing
12. Causal, by Taimur and Lukas