In today’s competitive economic climate, early-stage founders must be able to track and report their success using data. Investors want to see metrics, benchmarks, and milestones.
The best way to demonstrate your traction is through sound planning and impeccable financial hygiene. For startups, this often takes the form of either an annual budget or a financial model.
In this post, we’ll take a close look at the differences between an annual budget and a financial model. As you’ll see, while each tool serves a unique purpose, they work best in conjunction with each other.
Let’s dive in to examine some of the important differences between an annual budget and a financial model, and discuss how you can best use them to optimize your operation and raise the funds you need.
Table of Contents
- Annual Budget Overview
- How an Annual Budget Is Used
- Annual Budget Best Practices
- Financial Model Overview
- How a Financial Model Is Used
- Financial Model Best Practices
- Which Tool Is Best for Your Startup?
Annual Budget Overview
An annual budget documents a company’s plan for the income it expects to receive and the expense it expects to incur for one fiscal year.
It generally includes high-level assumptions about sales and other revenue, marketing initiatives, product development, research, infrastructure expenses, etc.
A startup budget typically begins with the previous year’s actual results as a baseline and then uses historical data and market trends to estimate income and allocate expenses for the coming year.
When you’re creating an annual budget, you want to use your income statement, balance sheet, and cash flow statement for different purposes.
First, your balance sheet provides insights into what your company owns (assets) and what it owes (liabilities). This will help you gain an understanding of how much cash you have available to cover your expenses for the year.
Your income statement will give you a clear picture of your revenue and costs. This is important because it helps you determine if your budgeted expenses can be covered by your available capital and anticipated revenue, or if you need to find a way to raise some additional capital.
Finally, your cash flow statement shows how much money is coming in and going out of your business each month. This helps you understand your runway, or how much time you have before you run out of cash.
How an Annual Budget Is Used
A budget lets founders set goals, allocate resources, and track their progress over the year. You can also use your budget to measure your performance against industry benchmarks and key competitors.
An annual budget is typically created at the beginning of the fiscal year, although you can manage your budget on a rolling basis.
Start by setting targets for income and expenses. Then check your progress against the budget periodically to see if your performance is keeping you in line with your expectations.
We recommend that our founders start using a solid accounting system on day one, but you can manage your budget in a simple spreadsheet if that’s all you have.
Annual Budget Best Practices
There are many different ways to approach creating your annual budget. It’s not rocket science, however, there are a few basic best practices that can help you get the most out of this process:
1. Start by looking at your previous year’s budget and results.
The best way to start setting targets for next year is to look at last year’s actual data. If you didn’t have a budget last year, use your financial statements to fill in the blanks. Last year’s actual performance is almost always the best baseline for next year’s targets.
2. Be realistic in your assumptions.
It’s essential to set achievable targets. If you’re not already familiar with the SMART goal-setting framework, learn it.
Outlandish targets and assumptions create two very negative outcomes. First, they set you and your team up for failure. Second, they diminish your credibility with everyone else – including potential investors.
3. Think about the long-term when setting goals.
While it’s essential to track your progress year over year and to use last year’s financials as your starting point, it’s also helpful to think about where you want your business to be in three to five years.
Comparing your current situation against your long-term goals exposes any incongruence between your expectations and your reality. If you don’t know how you’re going to reach those long-term goals, you need a financial model.
4. Create contingency plans.
Things rarely go exactly as planned. Think about the year ahead and try to identify the obstacles, conditions, and known issues that create risk in your plan.
Create contingency plans to respond if those potential problems become a reality. You don’t necessarily need to create a whole separate budget for every scenario, but you should document your contingency plans in the budget or an appendix.
Financial Model Overview
A financial model is a tool that lets you forecast your company’s financial performance. It pulls your three financial statements into a central place and uses your historical data to predict your future data.
With a financial model, you can look at different scenarios to see how your finances will be impacted by future events like key hires, product launches, or big funding rounds. It also lets you evaluate the impact of your daily decisions as a founder.
A financial model doesn’t replace your budget. It’s best used in conjunction with a budget to provide a complete picture of your company’s financial past, present, and future.
You can create a financial model in a spreadsheet. However, if you’re not a finance pro (or even if you are) you should consider a dedicated financial modeling solution like Forecastr. Software makes scenario planning a breeze, and it’s designed to share with investors.
You simply plug in your historical financial data and calculate your historical growth rates. Then you enter some assumptions to reflect how you expect those growth rates to change over time. If you work with Forecastr, a team of experienced financial analysts does this process with you.
How a Financial Model Is Used
Financial models are primarily used to monitor a company’s performance, assess risks, make decisions, and most importantly, avoid running out of money.
Financial models become extremely important in the fundraising process when you start talking to investors. But if you build a model for fundraising and fail to keep maintaining it after the round has been raised, you leave a ton of opportunity on the table.
With a model, you never wonder “What would happen if I increase the marketing budget by X?” or “What if interest rates go up by X%?” You just plug those changes into your model and you get a good estimation of their impact.
Financial models have been used for a long time by investment bankers and some specialized accountants. Today, you shouldn’t walk into a pitch meeting or make an important decision without one.
Financial Model Best Practices
At Forecastr, we talk about financial model best practices all day – we have a lot to say on the subject.
For this post, we’ll keep it short. Here are a few things you should keep in mind when creating your financial model:
1. Build from the bottom up.
When you build a financial model, always start with your historical data. Document your actual performance, and use projections that are consistent with the growth rates you’ve experienced so far.
The opposite of this would be a top-down model. An example is, “There’s a $25B market, and I think we can get 10% of it.” Don’t do this. It’s never a good look when your sales are $25K and your target is $2.5B.
2. Tailor your key metrics to your business model.
The best metrics for you to use for goal-setting and reporting depend on your industry vertical and your unique business model. Focus on the metrics that investors will want to see, and make sure your model lets you track them efficiently.
3. Keep your model updated.
Your financial model is a living document that gets updated regularly – we recommend once a month.
As your business changes, your financial model should reflect those changes as soon as possible. The longer you practice this habit, the more accurate your financial model becomes.
The opposite is also true. Your model drifts further away from reality the longer you let it sit dormant.
4. Make your model easy to understand and share.
When the time comes to start raising capital, you’ll need to share your financial model with potential investors.
Your 10+ tab spreadsheet might make perfect sense to you, but if a complete stranger can’t make sense of it within a few moments, it won’t have the impact you’re hoping for.
Investors look at financial models every day. You want yours to stand out – in a good way.
If you’re building a model in a spreadsheet, make sure it’s clearly labeled and easy to navigate.
To truly stand out from the crowd, consider investing in an online financial modeling tool that gives you elegant dashboards that are designed to be shared.
Which Tool Is Best for Your Startup?
Now that we’ve covered all the basics about annual budgets and financial models, let’s revisit the original question: Which one should you use?
The answer is both!
A budget is an essential tool for any business. Your board and your investors will expect you to maintain a solid budget, and it’s a useful tool for planning and monitoring your performance over one year.
A financial model lets you evaluate decisions, manage long-term goals, and monitor your cash runway. It will be required material when you start talking to investors, who need to see your vision and path beyond the coming year.
Together with your accounting system, a budget and financial model give you a complete picture of your company’s history, current situation, and likely future.
Forecastr helps early-stage startups build great financial models. Reach out today to get started.