Financial Modelling (Part 1 Cost)

In the past, I used complicated monthly projections where I tried to estimate both income and cost. Most of these models were linear, complicated, and easy to break. At the same time, these models were too simple and did not provide the information an investor needs.

?Nowadays I don’t do detailed projections more than 24 months out. These 12-24 models are to budget and to get a bit of a feel for the company but are not used for valuation purposes. After 24 months I focus on the important divers instead of trying to predict telephone costs in February 2028. Financial modeling is not about predicting the future but creating a better understanding of the value drivers both internally and externally.

In this article, I discuss 4 P&L drivers and 2 Cashflow drivers. These determine how much money a company can return to its investors without negatively affecting growth (Free Cash Flow)

How do you compete?

There are 3 different ways a company can compete.

·???????? Strong IP. These companies do things that other companies can’t do (or do them better). ASML and Nvidea are two prime examples but a (movie) company like Disney is another example.

·???????? Strong Brand. A strong brand creates network effects (Meta/Facebook), gives customers certainty of the quality (Coca Cola), or allows the customer to show off their wealth (LVMH)

·???????? ?Value. The company provides its customers with a good experience at a low price. Companies like IKEA, Lidl and Inditex

Some companies compete in more than one way. You could argue that Apple is both a Tech company and a Luxury company. Mcdonald's has a strong brand and offers great value (if you are a 10-year-old).

Every start-up must decide how to compete.

?Strong IP is the easiest to start with but also the easiest to get out-competed. The list of Tech companies that have risen and fallen is long and growing. If our company competes on IP, you need a smart and creative executive team. ?The more experienced and distinguished the better.

A strong brand is more difficult to create but also will stand the test of time better than IP companies. The older a brand gets the more valuable it becomes. The key is to do something unique/different that creates brand loyalty. Red Bull created a brand by becoming deeply involved in extreme sports. This allowed the company to compete in a saturated market dominated by big players. A founding team needs a good origin story/strategy and good personal skills.

Competing on value is difficult for a startup as they lacks economies of scale. You also want to communicate your great value with a minimum spend on marketing. A good idea that allows you low(er) direct costs is the starting point. For instance, the flatpacks from Ikea or the logistic strategy from Inditex. Once you get to economies of scale you can start competing against other companies.

P&L Drivers

Your strategy should be reflected in your cost structure. You can’t be an IP company with limited spending on R&D or a brand company with limited spending on marketing. Instead of predicting individual staff/costs I would encourage you to estimate how much of your turnover you can/should spend on R&D and/or Marketing.

For illustrative purposes I use the data set from Professor Damodaran (over 40,000 companies from 2014-2024) this gives a rough idea of sector averages.

Gross Margin

The most important driver to understand is your Gross Margin. Having an IP or Brand company with a low margin is difficult as you can’t pay for R&D/Marketing while for a Value company, it is the key differentiator.

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Sectors with strong IP and Brand loyalty like Biotech and Alcohol have high Gross Margin while Value sectors like Steel and Auto parts have low Gross Margins as they need to compete on price. ?

In industry sectors, there is a wide variety of GM's as companies compete in different ways. Gucci has a GM of 70% while H&M GM is 50%. The former is a luxury brand that will spend more on marketing while the latter is a Value brand.?

Research & Development/Sales

IP companies in the Pharma sector and tech sector need to spend a lot on R&D while Insurers and Food wholesalers spend little to nothing. Most IP-heavy start-ups need to spend 25% or more of their sales on R&D in their first 10-15 years. If you aim to be an IP company but only spend 5% on R&D in year 5 you will not convince an investor.

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Selling, general, and administrative expenses?(SG&A)/Sales

In most financial models the SG&A costs are underestimated especially for software companies. Most software companies have low direct costs but need employees to maintain the software and deal with the clients. Look at what peer group companies spend on SG&A if you spend less you need a good explanation (or adjust the spend).

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Net Margin

Once you have calculated your Gross Margin, R&D/Sales, and SG&A/sales you will know your net Margin. If the?Net Margin is above 25% you have to revisit your calculations or you need a good reason to explain these exceptionally high Net Margins. The net margin of ASML is around 25%, LVMH around 15% and Ikea around 5%. Tobacco companies are the big outlier with net margins close to 25%. Having addicted customers, laws against advertising spending, and price insensitivity (duty/taxes) help with the margins.

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Cash Flow drivers

These 4 P&L drivers you normally see (badly) modeled in monthly projections. What you rarely see but is important are the two cash flow drivers. It is great if you have a profitable company but if you have to spend money on Capex or Stock you can’t return a dividend. Net Capex and Non-Working Cash/Sales are just as important as Net Margin but don’t get discussed much.

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Net Capex/sales

Capital-intensive companies need to invest to grow. A leisure company needs to open new hotels, retailers’ new shops, and manufacturers new factories. It is no surprise that Green & Renewable energy companies have a high Capex and insurance companies have a low Capex. The former needs to build the machinery while the latter has a very scalable business that can be done from offices located anywhere.

You can calculate Net Capex in two ways. Either use industry/historic averages or estimates based on assumptions. For instance, if an average shop can do ￡1 mln in revenue with a Capex of ￡50k the Net Capex/Sales will be 5%

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Non-Cash Working Capital/Sales

Normally positive working capital is good as you can pay your creditors with your inventory and/or debtors making the company less risky, but from a valuation point, it is bad as the startup has to raise more capital (equity and/or debt) to grow.

Ideally, the customers and suppliers fund the growth. If your customer pays a 12-month contract upfront, accounting-wise you create a liability (deferred income) but that payment can fund the company's Growth. One reason SaaS companies are so valuable is that they receive their income upfront and can fund growth cheaply. Home building companies need to hold a lot of expensive sticks while insurance companies get their premium paid upfront. Again, you can use industry/historical averages to calculate Non-cash WC/Sales based on payment terms.

Conclusion

Once you have deteminted all 6 ratios. You can calculate your FCF/Sales ratio. Below 0% there is no reason for the business to exist. From 5% upward it start to become good (depending in you revenue growth).

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In a follow up artcile I will discuss the income side and how to calculate sensible Addressable Markets. If you got any questions don’t hesitate to contact Vivolution/me.?