Idiotopedia: Decoding the Numbers
#LongReading #IamNOTaCFA!
I've often found myself at the point where knowledge and stupidity meet when it comes to riding the tricky journey of the investment process, especially during the Financial Due Diligence (FDD) stage. After assisting my students and startup founders through these tricky processes, I've learned that they shouldn't be afraid of this process. Instead, it's an important measure that shows you how your business is doing. The FDD process isn't a chance to lie about numbers or make things look better than they are; it's a moment of truth that can either confirm your vision or show where the base is weak. But let me be clear: everything I'm about to share comes from what I know and have experienced. Again, by no means do I think I'm an expert. In my early years, I made a lot of stupid mistakes. My goal here is to help others avoid the same problems and do better than I did. So, let's look at how we can make FDD less of a tough job and more of a growth tool.
Let me start by saying that financial due diligence (FDD) is more than just a routine in the fast-paced and messy world of startups. It's a lifeline that can decide the fate of a young company. As a startup grows and stays alive, its financial stability is the most important. This framework must be carefully organized, closely analyzed, and reported clearly. Over the years, I've been through many different investor environments. I've seen first-deck documents (FDD) make or break deals during the seeding and pre-series A stages. Yes, you need to be more open and honest about finances during these stages, which are frequently characterized by uncertainty and high stakes, than the standard checklists. In fact, these overly simplistic models don't always show the complete picture of a startup's finances, leaving founders open to risks they didn't expect.
My note here directly challenges the industry's use of generic templates by going into detail about making a detailed, complete, and solid financial model that is perfect for the FDD process. My model isn't just about checking boxes; it's about giving accurate information that shows how complicated things are in the current investment climate. Using current funding trends unique to Indonesia, I want to help entrepreneurs understand how to do complex financial modeling for early-stage startups. All simulations will be done in IDR. After all, why should you use USD for everything when your business is in Indonesia? This tailored model ensures that the financial models are useful and based on the real world of the market you are working in.
WHY IS FINANCIAL DUE DILIGENCE IMPORTANT?
Again, there is a lot more to financial due diligence than just checking off a list. Finding the truth in a company's financial records is a careful process. It's not enough to just check the numbers; you need to understand what those numbers mean, figure out the business's strengths and flaws, and make sure that every line item shows how it works. This step is especially important for new startups because their financial records aren't always complete, their accounting methods aren't always consistent, and their predictions may be too optimistic. The stakes are even higher in places like Indonesia, where the startup community is changing quickly but still has trouble being open and consistent with regulations. Because early-stage startups are always evolving and there are external factors like unstable markets and economic instability, due diligence must be thorough and flexible to be tailored to each startup's specific needs.
Then, when doing financial due diligence on an Indonesian startup, things can get more complicated in ways that aren't as common in more developed markets. Many startups in this area are still very new, having been open for less than two years. This makes it hard to find accurate financial trends. There are also differences in how financial data is recorded and reported because there aren't any standard accounting methods. This makes the due diligence process even more difficult. Startups may also work in industries where things change quickly, making it hard to predict how they will do in the future with any degree of certainty. Changes in the value of currencies, new rules, and the competitive pressures of an economy growing quickly all make this instability even worse. So, doing financial due diligence in this setting takes a deep understanding of how the local market works and how unpredictable early-stage businesses are. Remember: It's not enough to just check the numbers; you also need to understand what they mean in a way that shows the business's real potential and risks.
BUSINESS PLAN
The first step in preparing for due diligence is to create a complete and flexible financial model that addresses the problems faced by Indonesian startups.
1. REVENUE ASSUMPTIONS AND FORECASTING
A. Seeding Stage: For startups in their seeding stage, typically under two years old, making a financial model is a delicate exercise in balancing optimism with caution. Given the lack of historical data and market presence, revenue forecasting at this stage can feel like trying to predict the future with little more than a gut feeling. Therefore, the financial model should prioritize conservative and realistic assumptions that ground the projections in a manageable reality. This includes developing a comprehensive scenario analysis that outlines worst-case, base-case, and best-case scenarios. Each scenario should be carefully plotted, considering potential market conditions, customer acquisition rates, and pricing strategies. A key focus for seeding stage startups must be cash flow projections, which are vital for understanding the runway available to the company. The cash burn rate—the pace at which the startup spends its cash reserves—needs to be scrutinized, as it often represents the Achilles heel for early-stage ventures. By modeling different cash flow scenarios, founders can better anticipate periods of financial strain and identify critical moments when additional funding may be required to sustain operations.
Let me share a simple simulation case;
Revenue and Expenses Overview:
??- Monthly Revenue: IDR 100 million
- OPEX: IDR 150 million (incl. salaries, rent, and marketing)
??- Cash Burn Rate: IDR 50 million / month
??- Initial Cash Reserves: IDR 500 million
??- Current Runway: 10 months (at the current burn rate)
Understanding the basics of financial matters is very important. Based on these numbers, the startup is spending money so quickly that it can only stay open for 10 months. I will use this as a starting point for my next simulation.
(1). Worst-Case Model:
??- Revenue Idles: Remains at IDR 100 million
??- OPEX Increase: 10% increase (to IDR 165 million)
??- Accelerated Cash Burn Rate: IDR 65 million per month
??- Consolidated Runway: 7.7 months
In this case, sales don't go up, and costs go up without warning. This speeds up the rate at which cash is being spent, shortening the runway and showing how important it is to plan for possible delays.
(2). Base-Case Model:
??- Revenue Growth: 20% increase (to IDR 120 million)
??- OPEX: remain at IDR 150 million
??- Decreased Cash Burn Rate: IDR 30 million per month
??- Consolidated Runway: 16.7 months
This case assumes that sales will grow moderately and costs will remain unchanged. The startup has more time to reach goals because the runway is longer and the cash burn rate is lower.
(3). Best-Case Model:
??- Revenue Growth: Doubles (to IDR 200 million)
??- OPEX: Slight reduction in OPEX
??- Cash Flow: IDR 50 million profit per month
??- Financial Stability: Cash savings grow instead of declining.
In the best case, the startup makes a lot more money and cuts costs at the same time, turning the cash burn into a positive cash flow. This situation protects the startup's finances and allows it to grow.
This simulation shows how important scenario planning is for financial modeling in the early stages of a company. By simulating different outcomes, founders can better prepare for the financial challenges ahead, handle their cash flow strategically, and make smart choices about when and how to ask for more funding. The model guides the startup through uncertain terrain, ensuring they are ready to adapt and survive even in the worst-case situation.
B. Pre-Series A Stage: Now, let's dive into startups progressing to the pre-Series A stage. With 3-5 years of operational history, the financial modeling process gains additional layers of complexity and relevance. At this stage, startups benefit from the availability of historical financial data, which offers valuable insights into the company's past performance. However, relying solely on historical data can be misleading, as it may not fully capture the startup's growth potential or the challenges that lie ahead. The financial model must go beyond past performance to incorporate current market trends, competitive dynamics, and broader economic factors that could impact the startup's trajectory. It's crucial to differentiate between one-time financial events, such as grants, awards, or unusual sales spikes, and sustainable ones. These recurring revenue streams are indicative of the startup's long-term viability. These distinctions help project a more accurate financial outlook and assess the company's ability to achieve profitability and scale. The model should also include sensitivity analyses that test how various factors—such as changes in customer demand, cost of goods sold, or operational expenses—could influence the startup's financial health. By building a robust and dynamic financial model, startups in this stage can present a more compelling case to investors, demonstrating where they have been, where they are heading, and how they plan to get there.
Similar to the above model, let me share another simple simulation case;
- Using Historical Data:
??- Operational: 3-5 years of financial data.
??- Historical Performance: Use past financial data to find patterns in your income, costs, and profit-making ability.
??- Beware of Overreliance: Historical data may not fully show how much growth there will be in the future or what new problems will arise.
The CFO or founders can use this formula to figure out growth rates from the past, which helps them make predictions:
Revenue Growth Rate = [(Revenue(Year X) - Revenue(Year X-1))] / [Revenue(Year X-1)] x 100
This model finds sales growth year over year. The average growth rate over the last 3 to 5 years can be used to set a new growth rate. This model helps predict future sales while considering changes in the market and competition.
Then;
- Using the Way the Market Works:
??- Market Trends: Use an analysis of current economic and industry situations.
- Competitive Analysis: Consider how the startup's competitors' actions may affect its market share and ability to set prices.
??- Other Factors: Consider macroeconomic factors like inflation rates, currency value changes, and customer behavior shifts.
This is how I usually adapt as the market changes; it's time to change income projections:
Adjusted Revenue Projection = Current Revenue x [(1 + Historical Growth Rate) x (1 + Market Adjustment Factor)]
Yes, this is where the Market Adjustment Factor considers competitive pressures, industry trends, and bigger economic issues that could affect future sales. This change ensures that the financial model stays useful despite changing the market.
- Setting Revenue Streams:
- One-Time Revenue Model: Identify one-time revenue sources, like grants, awards, or sudden sales spikes, and keep them separate from your regular income.
??- Recurring Revenue Model: Focus on sustainable, reliable ways to make money, like long-term contracts, subscription fees, or return sales.
??- Long-Term Viability: Evaluate whether the business can regularly generate recurring revenue. This is a key part of figuring out how big it could get in the future.
This is how I measure how long different sources of income will last:
Recurring Revenue Ratio = [Recurring Revenue / Total Revenue] x 100
A higher Recurring Revenue Ratio means that the startup's business plan is more stable and predictable, which is important for its long-term success and makes it more appealing to investors.
- Sensitivity Analysis:
??- Customer Demand Variations: Evaluate different demand models to see how they affect sales and profits.
- Cost of Goods Sold (COGS): Evaluate how changes in the cost of inputs affect general profit and gross margins.
??- OPEX: Note how expanding operations (like adding more people or doing more marketing) might raise costs and change cash flow.
You can use sensitivity analysis to find out how changes in key factors affect your profits; pretty straightforward as below:
Impact on Profit = (Revenue x Demand Scenario) - (COGS + Operational Expenses)
This model lets startups simulate various situations by changing factors like demand, cost of goods sold, and operational costs. It helps you assume how these factors might affect their total profitability. Again, this model allows the company to fully grasp the financial risks it faces and prepare for possible problems that might arise.
I use this simulation model to see startups move from the pre-Series A stage to the Series A stage; financial modeling gets more complicated. This means that past success and future predictions need to be carefully balanced. It is necessary to use algorithms to measure growth rates, account for changes in the market, and figure out how long income streams will last. For example, the Revenue Growth Rate model helps us understand how things worked in the past, while the Adjusted Revenue Projection model uses market factors to make predictions more accurate. The Recurring Revenue Ratio can also help startups show if they will be successful in the long run by separating recurring and one-time revenue sources. Sensitivity studies allow startups to predict how economic changes affect profits and prepare them for various economic scenarios. This all-around method of financial modeling shows where the startup stands right now and gives investors a clear and believable plan for how it will grow. When it comes to money, I think you already have a professional on your team who can do good accounting and use the highlighted numbers.
2. COST STRUCTURE AND MARGINS
A. Seeding Stage: In this case, costs usually go up more than income, which is OK. The main goal should be understanding the difference between set and variable costs, how they change as the business grows, and possible ways to cut costs without slowing down growth. Even if the margins are very small or negative, showing how to make money is important.
Let me also share another simple simulation for this:
- Cost Structure:
??- Fixed Costs: Costs that don't change no matter how much money you make (e.g. IDR 100 million a month for salaries, rent, and electricity).
??- Variable Costs: Costs fluctuate based on production or sales (e.g. IDR 50 million a month for marketing, supplies, and operational scaling).
??- Total Monthly Costs: IDR 150 million
It's normal for total costs to be higher than revenue in the seeding stage. The first step in financial modeling is dividing costs into fixed and variable groups. Variable costs should be closely watched as they grow, while fixed costs are long-term obligations.
- Cost Scalability:
??- Fixed Costs: It usually stays the same but might increase when you add more workers or office space.
??- Variable Costs: Directly related to increased sales (spending twice as much on marketing to get more customers).
??- Cost-Effectiveness Ratio: A model can determine how cost-effective something is as income grows. As an example:
Cost-Effectiveness Ratio (CER) = (Variable Costs / Revenue) x 100
Then, if Revenue = IDR 100 million and Variable Costs = IDR 50 million, CER = 50% —As sales increase, try to lower the CER to boost profits.
It's important to understand how costs change as businesses grow. The CER shows how well a startup can turn costs into income. A lower CER means the company better manages its costs as it grows.
- Margin Analysis:
??- Current Margin: With 100 million IDR in sales and 150 million IDR in costs, the profit is (-)50 million IDR.
??Target Margin: The goal is to achieve positive margins by making more money and cutting costs as much as possible.
??Profitability Target: To turn bad margins into positive ones, you need to manage cost growth while generating more revenue.
Yes, margins are often negative in the beginning, which is normal. The financial model should include a clear path to success that shows how margins will improve as sales increase and costs decrease.
- Cost-Efficiency:
??- Non-Essential Expenses: Review variable costs often to see if they can be lowered without hurting growth (e.g, you could renegotiate supply contracts or find better ways to spend your marketing budget).
??- Automate Processes: In the long term, investing in automation can lower both set and variable costs, which can help profit margins.
??- Break-Even Analysis: Use the following model to find the point where total costs equal total income:
Break-Even Point (BEP) = Fixed Costs / (Revenue per Unit - Variable Cost per Unit)
Let's say that Fixed Costs = IDR 100 million, Revenue per Unit = IDR 10 million, and Variable Cost per Unit = IDR 5 million. Then, BEP = 20 units.
Indeed, early-stage startups must find ways to cut costs without sacrificing growth to start making money. The break-even analysis is a key part of figuring out when the company will start making money, giving the founders a clear goal to work toward.
My note on this matter is that cost structure and margin analysis are important parts of financial models for startups in the seed stage. Divide costs into 2 groups: fixed and variable. This helps founders understand their financial responsibilities and how they change as the business grows. The cost-effectiveness ratio and the break-even analysis are 2 simple but useful mathematical mechanisms for figuring out how profitable and efficient a business is. The goal is to show how to make money, even if margins are negative. Focusing on these areas can help startups plan for long-term financial stability, ensuring that growth doesn't come at the cost of long-term success.
?B. Pre-Series A Stage: Startups should be able to see their costs more clearly. The model should put profits through stress tests in various economic situations, including inflation, currency changes (IDR's volatility, anyone?), and possible problems in the supply chain.
In this case, you can see from;
- Cost Visibility:
??- Identified Cost Components: Variable costs (e.g. production and marketing) and fixed costs (e.g. rent and pay)
??- Historical Data: 3 to 5 years of operational history allow for cost analysis.
??- Gross Margin Calculation:
Gross Margin = (Revenue - Cost of Goods Sold) / Revenue
At this stage, startups can easily tell the difference between set and variable costs thanks to data from the past. This makes it possible to get a more accurate picture of gross margins, which are important for determining profitability.
- Economic Variability:
??- Inflation Impact: Costs will go up by 5% to 10% because of inflation.
??- Currency Exchanges: Consider how a 5% drop in the value of the Indonesian Rupiah would affect costs and revenue.
??- Supply Chain Model: Costs go up by (avg) 15% because of problems in the supply chain.
Setting the financial model through different economic possibilities to see how it works helps find any possible weak spots. For example, if inflation raises prices by 10%, the new business must determine how this will affect its ability to make money. In the same way, changes in currencies, especially the IDR, can have a big effect on prices, especially if the startup needs to import goods or services.
- Profitability Model:
??(1) Case 1 (Inflation):??
? ??- Increased Costs: Costs increase by 10%, lowering the gross margin.
? ??- Adjusted Gross Margin:
New Gross Margin = (Revenue - Increased COGS) / Revenue??
? ??- Derivative: Consider that inflation will affect the startup's profitability.
??(2) Case 2 (Currency Fluctuation):??
? ??- IDR Depreciation: 5% rise in costs because the currency has lost value
? ??- Revised Profit Margin: Change the profit margins using the new cost structure.
? ??- Derivative: Consider how it affects profits and whether cost changes must be made.
??(3) Case 3 (Supply Chain Model):
? ??- Cost Surge: 15% increase in COGS because of problems in the supply chain? ?
? ??- Adjusted Gross Margin: New Gross Margin determined with higher costs? ?
? ? - Derivative: Determine if the new business can handle the higher costs or pass them on to customers.
Each case helps the startup determine how well its cost structure can handle tough economic times. By examining the gross margin in these different situations, the startup can tell if it is still profitable or needs to change its business plan.
For pre-series A startups, having a good knowledge of their margins and costs is important. These new businesses can correctly figure out their gross margins and see which parts of their business are most affected by changes in the economy by looking at data from the past. Stress tests for inflation, currency fluctuations, and supply chain problems help startups figure out how these things might hurt their profits and plan how to handle them. With the given model, quick recalculations are possible. This dynamic approach to financial modeling helps startups deal with uncertain economic times by giving them a better picture of their financial health.
3. VALUATION TECHNIQUES
A. Seeding Stage: It's more of an art than a science to value things at this stage. Often, old methods like Discounted Cash Flow (DCF) might not work because the cash flows aren't stable. Instead, a more balanced view might come from combining the Risk Factor Summation method (which looks at risks unique to the company) with the Berkus method (which focuses on qualitative factors).
- Challenge of Valuation:
??- Art vs. Science: A seedling-stage business has no stable cash sources, and valuation is subjective.
??- Problems with Using Traditional Methods: Discounted Cash Flow (DCF) is often not a good method to use when there are uncertain revenue lines.
My simple comment on this stage is that there's more to valuing a seed-stage startup than just numbers. You need to know a lot about the business's prospects and the market it's in. Because startups are volatile and still in their early stages, traditional pricing methods like DCF, which depend on steady cash flows, don't always work.
- Berkus Method:
??- Qualitative Factors: This method focuses on factors such as the team's strength, progress in product creation, and market size.
?? - Monetary Assignments: Each factor is assigned a specific monetary value, which is added to get an idea of the company's potential worth.
I think using the Berkus Method during the seeding stage is best because it looks beyond the numbers and the important factors determining the company's future success. This method helps make a more realistic valuation by assigning money to important success factors like a strong team or a well-developed product.
- Risk Factor Summation Method:
??- Risk Assessment: To use this, you have to figure out what risks the startup has, like technology risk, business risk, and market competition risk.
??- Risk Premium Adjustment: A risk premium is either added to or removed from the base value based on the general risk profile.
The Risk Factor Summation Method adds another level of risk analysis to the Berkus Method. It finds the startup's specific risks in a planned way and changes the value to reflect those risks. This method ensures that the valuation considers the possible benefits and risks that could slow the company's growth.
Let me make another simple simulation for this balance valuation model;
(1). Berkus Method:
- Give each qualitative factor a monetary value, such as IDR 200 million for the team, IDR 300 million for the product, and IDR 400 million for the market possibility.
- Add up these numbers to get a rough idea of how much something is worth.
- Value = IDR 200 million for the team, IDR 300 million for the product, and IDR 400 million for the market potential, which equals IDR 900 million.
(2). Risk Factor Summation Method:
- List the most important risks, such as market competition, the spread of new technology, and governmental roadblocks.
- Present each risk with a risk premium that is either positive or negative based on how bad it is.
- Adjust the starting value by adding or taking away the risk premiums.
- If the total risk adjustment is IDR (-)100 million, the end value is IDR 800 million (IDR 900 million - 100 million).
These methods show how important it is to use qualitative and quantitative analysis to determine how much a seed-stage business is worth. The Risk Factor Summation Method ensures that the valuation considers the startup's unique problems, and the Berkus Method helps founders put a number on the non-financial aspects that drive their business. This valuation is more than just a number; it shows the business's promise and risks. This way isn't as accurate as other approaches, but it gives a fair and accurate picture of how much a startup is worth in its early stages. So, I recommend being open and honest with the investor about your goals and strategy at this stage.
B. Pre-Series A Stage: A more standard method can be used but with some modifications. The Venture Capital (VC) method considers the exit value, the expected return on investment, and dilution. It could be used with the DCF method.
- Traditional Valuation Methods:
??(1). Discounted Cash Flow (DCF) Method:
? ??- Objective: It forecasts future cash flows and brings them down to their current value.
? ? - Application: Startups established for 3 to 5 years can use their past financial data to guess how much cash they will make.??
? ??- Adjustments: Since startup environments are often unstable, estimates about growth rates and discount rates should consider the market's current state and the risks that come with early-stage businesses.
Yes, this DCF method is a more organized way to value a startup because it focuses on the company's actual value. However, assumptions must be carefully calibrated to ensure the model accurately reflects the startup's working environment.
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(2). Venture Capital (VC) Method:
??- Exit Valuation:
? ??- Objective: Assumes the startup's possible exit value by looking at similar market deals.
? ??- Application: To come up with a reasonable exit value, the founders should look at the market potential, the valuations of competitors, and the growth of the industry.
??- Investment Return Expectations:
? ??- Objective: Choose investors' required return on investment (ROI).
? ??- Application: The estimated return on investment (ROI) should be included in the model. This is usually between 10x and 20x for early-stage startups, considering market risks and growth potential.
??- Dilution Consideration:
? ??- Objective: Considers how future funding rounds will affect the ownership numbers already in place.
? ??- Application: For the model to understand how future investments might affect founder and early investor stakes, it should simulate different situations of equity dilution.
As I have experienced, this VC method complements the DCF method by including market-driven factors like expected return on investment (ROI) and exit values. It greatly helps startups in the pre-Series A stage because possible returns and future funding changes greatly impact valuation.
Let me share a simple model that combines both DCF and VC methods that can be used to evaluate how well this financial modeling works:
1. Forecast Cash Flows:
? ?- Forecast the startup's cash flows for the next 5 years using data from the past.
? ?- My simple understanding of this is:
Projected Cash Flow = (Current Revenue x Expected Growth Rate) - (Operating Expenses + CapEx)
2. Discount Cash Flows:
? ??- Use a discount rate appropriate for the startup's risk level.
? ?- How?
Present Value = Projected Cash Flow / (1 + Discount Rate)^n
3. Calculate Exit Valuation:
? ?- Use benchmarks and market comparables from the same business.
? ?- Again, this is my simple way of using:
Exit Valuation = EBITDA x Comparable Multiple
4. Calculate Required ROI:
? ?- Find the return on investment (ROI) investors want based on the time they are willing to spend.
? ?- How?
Required ROI = (Exit Valuation / Investment Amount)^(1/Investment Period) - 1
5. Dilution:
? ?- Show how future rounds of funding will affect things.
? ?- Use this way:
Post-Dilution Ownership = Pre-Dilution Ownership x (1 - New Funding Round % Equity)
Again, when you use DCF and VC methods together, you can get a more accurate financial picture of pre-series A startups, considering their actual value and market potential. The suggested model gives a structured way to guess future cash flows, lower them to their present value, and take into account market-driven factors like expected exit prices and return on investment (ROI). This 2-part method ensures that the valuation shows the startup's real potential while also considering the risks and unknowns of early growth. The model also helps founders and investors determine how future funding rounds might change control stakes, which allows them to make better decisions.
4. WORKING CAPITAL MANAGEMENT
A. Seeding Stage: This is where many new startups fail. A full working capital forecast should be part of the financial model, focusing on keeping money on hand. A liquidity crunch can happen when founders don't notice the time lag between money coming in and going out.
Let me build the sample case; these are just the numbers I thought were typical of best practices in the business:
(1). Working Capital:
??- Components: Cash, Accounts Receivable (AR), Accounts Payable (AP), Inventory
??- Cash Balance: IDR 500 million
- AR: IDR 200 million (in 30 days)
??- AP: IDR 150 million (in 15 days)
??- Inventory: IDR 50 million (turnover period of 60 days)
Managing working capital is important for keeping cash on hand. In this case, the startup's short-term financial health depends greatly on its starting cash balance and when its receivables and payables are due.
(2). Case Analysis:
??- Cash Conversion Cycle (CCC):
? ? - Days Sales Outstanding (DSO): 30 days
? ??- Days Payable Outstanding (DPO): 15 days
? ??- Inventory Turnover: 60 days
? ??- CCC:
(DSO + Inventory Turnover Days) - DPO = 75 days
This Cash Conversion Cycle (CCC) is an important model for figuring out how long it takes to turn goods into cash. A longer CCC could mean problems with liquidity because cash is stuck in operations for a long time.
??- Impact on Liquidity:
? ??- Cash Flow Gap: Because the CCC is 75 days, the startup has a cash flow gap because it needs to pay its providers within 15 days but has to wait 30 days to get paid by its customers.
? ??- Working Capital: To close this gap and exit a cash flow problem, an extra IDR 100 million might be needed.... or?
Again, this CCC stresses the need for more working cash to keep the business liquid. If this gap is not handled well, it could cause a cash flow problem, which could mean the startup needs to look for emergency funding or wait to pay its suppliers.
- Simple Assessment:
??- Working Capital Ratio (WCR):
WCR = (Current Assets / Current Liabilities)
??- Target: A ratio above 1.5 is best for keeping enough cash on hand.
??- Current Ratio:
? ??- Current Assets: IDR 750 million (Cash + AR + Inventory)
? ??- Current Liabilities: IDR 150 million (AP)
? ? - WCR: 750 / 150 = 5.0
This model is reviewed to determine whether the startup has enough assets to meet its short-term commitments. The startup has a lot of working cash, with a ratio 5. However, the longer the CCC is, the more dangerous it could still be if debts are late or inventory turns over slowly.
I note that many startups don't realize how important it is to handle their working capital when starting. This can make it hard to get cash, putting activities at risk. Then, by adding a thorough working capital forecast to the financial model, the founders can see where cash flow gaps might occur and take steps to avoid them before they happen. The Cash Conversion Cycle (CCC) is an important financial tool showing how well a company handles its cash flow. While a good working capital ratio is helpful, the real test of a startup's financial strength lies in its ability to control when cash comes in and goes out. Startups can better prepare for the expected cash flow problems that will come up by using scenario analysis. This way, they can ensure they have the cash they need to get through the early stages of growth.
?B. Pre-Series A Stage: Startups should show they can effectively handle their cash. Their WCRs should be added to the model, and a sensitivity analysis should be done to see how changes in payment terms or the number of sales could affect liquidity.
Again, let me add another sample case;
- Working Capital:
??- Current Assets: Cash, AR, and goods add to IRD 2 billion.
??- Current Liabilities: IDR 1.2 billion (AP and short-term debt)
- Current Ratio: 1.67 (Current Assets / Current Liabilities)
Here, a current ratio of 1.67 means that the startup's short-term assets are equal to its short-term debts, which means that its working capital is in a pretty good place. However, this standard needs more analysis to handle market changes.
- Sensitivity Analysis:
??(1). Case 1 - Decreased Sales Volume:
????- Sales: 20% drop in sales volume
????- AR: It has been lowered to IDR 1.5 billion.
? ??- Current Ratio: 1.25
????- Liquidity Impact: Less cash on hand, but still above the important level of 1.0
In this case, a 20% drop in sales means less cash coming in, less money coming in from AR, and less money available. The current ratio goes down but stays above 1, so the startup can still pay its bills in the short run.
??(2). Case 2 - Extended Payment Terms:
? ??- Payment Terms: 30 days added to the average payment terms
? ? - AP: It went up by IDR 1.5 billion.
? ??- Current Ratio: 1.33
? ??- Liquidity Impact: Cash flow is being strained more, leaving less room for unexpected costs.
In this case, longer payment terms for sellers mean more bills to be paid, which puts more strain on the startup's cash flow. The current ratio goes down, which shows how important it is to handle cash flow carefully.
??(3). Case 3 - Inventory Model:
? ??- Inventory Increase: 15% rise in inventory because sales have slowed down
? ??- Working Capital: Current assets increased, but cash flow decreased.
? ??- Current Ratio: 1.58
? ??- Liquidity Impact: When inventory builds up, cash gets stuck, which lowers liquidity even though the current ratio is higher.
In this case, adding more inventory might improve the current ratio, but it also locks up cash, making it harder for the startup to meet its short-term commitments. This shows the importance of understanding the ratio and what the numbers mean.
Now, let me try to check the accuracy of the financial models and figure out how efficient the working capital is:
1. Current Ratio:
Current Ratio = Current Assets / Current Liabilities
? ?- A current ratio above 1.5 is generally considered healthy, but sensitivity analysis is essential to understand potential impacts on liquidity.
2. Quick Ratio:
Quick Ratio = (Current Assets - Inventory) / Current Liabilities
? ?- This model is a stricter liquidity test because it doesn't include inventory, which might not be easy to turn into cash quickly... I called this a brute-force style!
3. Working Capital Turnover Ratio:
Working Capital Turnover = Sales / Working Capital
??- This ratio shows how well a business uses its working capital to make sales; a higher ratio is more efficient.
4. Sensitivity Analysis: Test the above ratios in various situations, such as when sales go down, payment terms get longer, or inventory builds up, to see how they affect liquidity and working capital management.
This analysis shows the importance of handling working capital well in the pre-Series A stage. Startups can determine their financial stability in different market situations using working capital ratios and sensitivity analyses. The financial model is an important tool for making sure that the startup stays liquid, can meet its obligations, and is ready to take advantage of opportunities without falling into the usual mistakes of taking on too much debt or not managing its cash flow well.
5. FINANCIAL HEALTH CHECK
A simple but useful model can be made to determine how financially stable a business is (If you are the CEO, ask your financial expert to make a rough draft that you can hand in on one sheet of paper). This model should include key financial measures like the Current Ratio, Quick Ratio, Gross Margin, and Operating Cash Flow Ratio. The model should give more weight to cash flow management and runway analysis for startups in the seed stage. For startups before series A, measures like return on investment (ROI) and profitability should be given more weight.
Again, I have made 2 models with SaaS and Fintech startups that I have looked at in their early days. These models will help make this simulation more like the real thing:??
(1). SaaS - company X (Less than 2 Years):
??- Annual Revenue: IDR 500 million
??- Cash Burn Rate: IDR 600 million
??- Fixed Costs: IDR 400 million (salaries, rental)
??- Variable Costs: IDR 200 million (server maintenance, marketing)
I note that they make IDR 500 million a year but spend IDR 600 million a year, which shows that they need to be careful with their money. Most of the costs are fixed, like rent and salaries. Variable costs, on the other hand, include things like marketing and server repair that are needed to run the business.
- Discounted Cash Flow (DCF) Valuation:
??- Cash Flows: Based on the current arrangement of revenue and expenses
??- Net Present Value (NPV): Since the burn rate is higher than the revenue, it's likely to be negative.
??- Financial Report: Replace quantitative points with qualitative ones
I can say that a DCF-based estimate would likely show a negative net present value (NPV) because the revenue and costs don't add up. This means that the company might be unable to defend its value using only financial information. So, things like the strength of the starting team, how well the product can be scaled, and the size of the possible market should be given more weight.??
- Financial Assessment:
??- Revenue Growth Rate (RGR):
(Revenue Year 2 - Revenue Year 1) / Revenue Year 1
??- Burn Rate (BR):
Fixed Costs + Variable Costs - Revenue
??- Runway:
Cash Reserves / Monthly Burn Rate
??- NPV:
Sum of (Cash Flows / (1 + Discount Rate)^n)
I use this model to determine how financially stable this startup is: Figure out the Revenue Growth Rate (RGR) to see how things are going from one year to the next. Find out the Burn Rate (BR) to see how fast the business spends its cash on hand. Runway helps the business determine how long it can stay open before needing more money. Lastly, NPV can be used to determine if the startup can make money in the long run. Because the NPV is negative, looking at the company's prospects in more than just financial terms is important.
This simulation gives a good picture of the money problems a SaaS business in its early stages has to deal with. If a business's annual costs exceed its yearly income, conventional valuation methods like DCF might not paint a positive picture. However, using a structured financial formula, the startup can better understand where it stands now and how far it can go. It also knows it must stress more qualitative factors when talking to investors. This method provides a complete picture by balancing numerical analysis with the business's larger potential. It also gives the company a clear financial plan to help it through its early stages.
(2). FinTech - company Z (3-5 Years):
??- Annual Revenue: IDR 5 billion
??- Growth Trajectory: Steady growth over 3-5 years
- Challenge: Inflation is driving up costs and reducing the profit margin.
In its pre-Series A stage, a fintech business should start the financial model by knowing how its sales are growing and what's putting pressure on its margins. Even though the startup has shown progress, outside factors such as inflation can be very difficult.
- Inflation Impact on Costs:
??- Cost Increase: Business costs increase by 10% because of inflation.
??- Margins: When profit margins get smaller, it's less profitable.
??- Adjusted Financials: Net revenue and cash flow are affected when operating costs increase.
This effect of inflation on the startup's cost structure means that financial forecasts need to be looked at again. This shows how important it is to change the financial model and consider economic factors that the startup can't control, as these can greatly affect its finances.
- Working Capital Simulation:
??- Current Working Capital: Good, but under pressure because costs are going up
??- Outcome: Potential financial problem within 12 months is revealed
??- Decision Point: To avoid cash flow problems, you need more money or to find ways to cut costs.
This working capital simulation is necessary to determine whether the startup can maintain its cash flow even if costs increase. Without help, like getting more money or figuring out how to cut costs, the model shows that the startup could run out of cash within a year.
- Financial Assessment:
??- Components: Key financial measures like Operating Margin, Current Ratio, and Cash Conversion Cycle should be included.
??- Margin Analysis:
Operating Margin = (Revenue - Operating Costs) / Revenue
??- Liquidity Monitoring:
Current Ratio = Current Assets / Current Liabilities
??- Cash Flow Impact: To see how different cost factors affect cash flow, you can simulate it.
The model uses these financial formulas to numerically evaluate the startup's financial health. The Current Ratio shows how well the company meets its short-term obligations, while the Operating Margin shows how well it manages its costs and revenue. By simulating cash flow under different cost situations, you can better understand possible liquidity problems.
For an early Series fintech startup, keeping its finances stable is crucial, especially when outside forces like inflation decrease costs and margins. Founders can find possible liquidity problems early on by changing the financial model to reflect these facts and running a stress test on working capital. They can take the necessary steps, like getting more funding or finding ways to cut costs, to ensure the startup stays on solid financial ground because they are aggressive. Financial models improve the model's ability to give useful information, making it an important tool for managing the complicated financial world at this growth stage.
THE ECONOMIC THEORY BACKDROP
Anyway, let me twist a bit based on my experiences. Most startups fail, even with all the financial modeling, analysis, and economic theory. That's fine. In reality, neither a model nor a script can predict what will happen, and they can't plan for every problem. On the other hand, the survivors can change their plans when needed and learn from their mistakes. When you write your financial report, remember it's not just to please investors or check off a list. It's about getting to the heart of your business, being honest about its weaknesses, and making a plan for the future based on truth, not just hope. People who follow the norm would tell you to pay close attention to the numbers. Read the story those numbers are telling you, and be ready to change it as you go.
This isn't just a financial due diligence opinion; it's like the startup version of "survival of the fittest." That means you must be ready to follow your rules if you want to play.
Enjoy the journey, and Good luck, young Jedi!
Ref.