Complete guide to financial modelling for Start ups – Part I

“How would I take this forward? I know nothing about start-ups”, wondered Aparna as she sipped through the 8th cup of coffee on another sleepless night. Aparna had quit her job as an apparel designer with one of the leading fashion houses in India and wanted to start something of her own. After working for 5 years with the fashion brand, creative satisfaction eluded her and she wished to explore the bridal outfit market with her own collections.

Quite familiar with the app culture these days, Aparna planned to penetrate the market by opening an online store which could be accessed through an app. While the app development was assigned to a friend of Aparna, she became wary about other aspects. She knew nothing about the financials or metrics to analyse the business. Making projections and raising funds sounded alien to her. But she had a vision and was keen on making it successful. So she approached her friend, Reena, who was an expert Financial Analyst.

Reena explained that for the financial projections of the business, Aparna must keep two aspects in mind:

1) Instead of building a financial model in an existing template, Aparna must build one from scratch. Each business has a unique revenue model with a different set of assumptions that only the owner of business knows. By building the entire model from scratch, Aparna would become aware of each revenue driver, the assumptions behind it, a realistic view of the expenses and the expected market trend.  This will help her to manage the business better.

2) It is a commonly followed practise by start ups to build a financial model only from funding perspective. This is not advisable. Building a model only to impress investors can be detrimental to the business. The model needs to be built with integrity and a long-term view of business. Aparna grew curious and asked Reena about the various important metrics that she must focus upon while building the model. Reena shared her expertise and explained Aparna about each of the 10 important metrics which are crucial before building a financial model.

  • go site Customer acquisition cost (CAC)

Customer Acquisition cost (CAC) is one the most important metrics of a start up business. Customer acquisition cost refers to the cost that goes into winning a customer. For eg: If Aparna spends Rs 50,000 in marketing and promotion of her website annually and acquired 100 customers in a year, then the CAC will be Rs 500. However, CAC means nothing in isolation. It needs to be measured in relation to the Long term Value (LTV) of business which means the profit earned from each of those customers over the given period. Hence, Aparna has to aim at reducing the CAC over the years and increase the LTV to make her business profitable.

 

This metric refers revenue earned per account. For e-commerce business like that of Aparna’s, this is an important metric. It is to be noted here that instead of each user we are referring to each account because a single user can have multiple accounts. This metric will help Aparna to understand the revenue generation capacity at per unit level and analyse the popularity of each product. This will be useful to both Aparna as well as investors, as it will allow her to plan her line of products in future.

Customer Acquisition Payback Period, also known as the sales efficiency refers to the time taken to recover the amount spent on acquiring a customer. The shorter the payback period, the more profitable the business. Shorter payback period means the customer acquisition strategies have been used efficiently. Aparna can calculate the customer payback period using the formula as:

While established companies are usually analysed quarterly or annually, start ups are better analysed monthly. But the monthly growth rates may vary significantly and lead to more confusion for Aparna. Hence, it is advisable to use Compounded Monthly growth rate as a more reliable measure to keep track of the business’s performance. The Compounded Monthly Growth rate (CMGR) can be simply calculated as:

Wouldn’t it be great if customers could be retained for a lifetime? But unfortunately that doesn’t happen. Customers cease to continue and drop out. This is called churning. At the same time new customers keep getting added. It would be difficult for Aparna to keep track of such numbers each month, but she can measure the same by a metric called Churn rate. Monthly Churn Rate would tell Aparna about the total number of customers that she lost in a particular month. Aparna would also have to keep track of Churn rate prevailing in her industry and gradually learn to predict the rate. Ideally her aim should be to reduce the Churn rate by taking steps to retain customers.

  • follow Daily Active Users/ Monthly Active Users 

It is important for Aparna to understand the engagement on her online bridal outfit store because it will help her to take necessary feedback from the active users. When we talk about daily active users, these are the ones who visit the web store on a daily basis. Similarly, the Monthly active users refer to the number of users regularly active in a month. However, both these measures excludes one-time users. Keeping a track of regularly active users would help Aparna to understand what makes them come back to her portal and accordingly she can enhance the features to draw more users on it.

The amount of cash that goes out every month from a business is the monthly gross burn. This includes all the cash outlays and expenses incurred by a business. Aparna needs to diligently keep a track on it. This would help her to know how long the business would survive, how long it would take to break even or how early she can start generating profits. Another metric that can be used by Aparna is the Net Burn Rate. Net Burn Rate is the difference between revenues and gross burn.

The standard gross margin which means the profit earned after deducting the direct expenses of production. Though it is one of the most common metrics in business, it has special significance for Aparna’s start up. Usually new businesses tend to spend a lot more cash in setting themselves up than the established businesses. Aparna needs to maintain a proper check on the gross margin because it directly shows the ability of the business to sustain itself and meet production related expenses.

Before launching her business, Aparna needs to know the total size of her product’s market. This depicts the total available opportunity for her products. This refers to the potential market if her product had 100% of the market share. Total Addressable market would help Aparna to further filter it down to SAM or the Serviceable Available Market which will be the market which can actually be reached. Filtering down further would give Aparna her actual target market which would contain her likely customers/ buyers. This kind of layering approach would help to do detailed profiling and segmentation of the market so that she can customize her offerings accurately.

Cohort Analysis is a way of grouping the customers, known as cohorts, so that they can be analysed their pattern of engagement. In cohort analysis, the customer’s pattern of product engagement is grouped into days, weeks and months and studied in details. The cohort segmentation varies from business to business, but the aim is to group the customers according to smallest possible time duration so as to analyse the customer behaviour in maximum details.

source Financial Model for Start up

Now that Aparna knows about the crucial metrics that is needed to monitor the start up, Reena plans to explain Aparna step by step about building a financial model for her bridal outfit web store.  So stay tuned as we learn about the main steps to build a financial model for an e-commerce company in the next series.