Financial Modeling Part 1 – What is a Financial Model?
Transcript
We're going to try something new with these videos. You see, one of the talks that I give that is most popular around the Techstars network is about financial modeling and how to create a financial model for your startup. And so it's a long talk. It takes me two hours to get through all this material. But what I've done is I've chopped it up into bite-sized pieces so that you can hopefully get it in a digestible form. So before we talk about financial modeling and how to do it, we have to discuss the why. Why is financial modeling even valuable?
And you see, before we can talk about that, we have to be straight on our terms because
people get confused.
They get confused about what a financial model actually is.
Many people confuse financial projections for a financial model.
Financial projections are simply a forward-looking statement.
Sometimes an income statement, balance sheet, even statement of cash flows, but they're
static.
You see a financial model is actually the mathematical representation of how your business
works, how everything is interrelated.
It has inputs, which are assumptions, and it has outputs, which are financial projections.
The same mathematical model, the same financial model can actually produce different sets
of projections.
Sometimes I'll see them optimistic, pessimistic, realistic to give the investor a sense of
What's the range of possible outcomes?
So now that we're talking about a financial model,
I'm going to take a little bit of a walk into the past.
This is how they used to design automobiles.
This is a clay model.
They started with an eighth scale clay model.
This is from the 40s.
And when they liked the shape of it and everything was perfect,
they would make a full-size scale model.
And they'd make it out of all clay.
It's kind of crazy.
You see there are these headlights and rubber tires,
but everything else is clay.
And they'd make this full-size clay model.
And when they were done, they'd actually produce a sample of the automobile out of steel with an
engine and seats and everything else. And then what they do is they'd have to test it. So they'd
take it out to the test track. They'd put a test driver in the seat, buckle the driver in, send
them off to go around the track. And there's a particularly tight hairpin turn that you have to
execute at 30 miles an hour safely. So the first time the test track goes off, the test driver goes
around 30 mile an hour hairpin turn and boom the car flips over. So what do you do? You go back to
the drawing board. You go back to the eighth scale clay model. You make it more stable by making the
wheelbase wider, lowering the center of gravity, whatever it takes. When you get that perfect you
make a full-size scale model. When you get the full-size model done both front and back then you
make a full-size car out of steel. Hopefully by now six or 12 months later the test driver's out
of the hospital, you put that driver back in the seat, buckle him or her up really tightly
and send them back off.
Hopefully they make it.
You see, we don't do this anymore.
It's too costly.
It takes too much time.
What we do today is we use CAD programs.
We draw it on the computer, right?
We get these beautiful renderings of what the computer thinks the car is going to look
like even in 3D.
But the real value of it isn't just that we can see it on the outside, but we know everything
about that car. It's been modeled. We take the drawings of the inside and can actually see the
inner workings of the pistons, everything. But that still isn't the real value. The real value is
that we don't have to build a physical model to test it. You see, if we know the mass, the center
of gravity, coefficient of friction, all that stuff, we can actually take our car on a virtual
test drive. We can take that car on the track, take it around the hairpin turn, and when it flips
at 30 miles an hour. We didn't risk someone's life. We didn't crash a car that costs millions
of dollars to develop. We didn't waste a lot of time. We just go back to the CAD drawings,
say, you know, we're going to make the wheelbase six inches wide, or we're going to lower the
center of gravity. And not six or 12 months later, but six or 12 minutes later, we're back on the
virtual test drive. Now, I believe that each of you would love to have a virtual test track for
your business where you could do what if and you could test what would happen to my business what
is the outcome before you actually spend years trying to execute on it before you spend hundreds
of thousands or millions of dollars trying to execute on it and that's what the financial model
will do now we have lots of financial tools at our disposal today many of you for instance will use
accounting quickbooks right it's a great tool it produces an income statement of balance sheet
cash flows, but it tells you what's happened in the past. It's like looking at a rear view mirror
and trying to drive your car with only the information that's in the rear view mirror.
None of you would try to do that. We have other financial tools at our disposal,
like a dashboard, or in our case, it looks something like this, KPIs. Tells you what's
happening right now. Again, you wouldn't drive your car staring down only at the dashboard.
that wouldn't work very well you'd much rather be able to see forward and see out the front
windshield of the car imagine trying to drive a car in the city without being able to see
forward that's what it's like if you don't have a financial model you see financial model is one
of the only tools that is forward looking and will tell you where you are going giving you clear vision
for the road ahead so in the next few episodes we're going to talk about how to actually build
a financial model and how to use a financial model and hopefully show you how it is so
valuable that you'll invest the time to build your own and that will help you have a greater
chance of being successful in your next venture.
One of the things Troy is most well-known for in the entrepreneur community is his Financial Modeling Workshop. We’ve decided to break down his typical 2-hour presentation into bite-sized pieces. Today is Part 1 of many in Troy’s MATH 101 Financial Modeling Series.
Originally published on the MATH Venture Partners blog.
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