I’ve always received this question regarding the financial model – Why do investors require a 3 statement financial model?
In all honesty, depending on your startup’s stage, sometimes an income statement is more than efficient to pitch for investment or to showcase your company’s growth. However, a three-statement financial model is essential because it shows your cash flow at specific moments in time. This is vital for many investors out there.
The Importance of Cash Flow
A good example is OpenAI and its current performance.
Now, OpenAI is a company that generates millions in revenue every month, and it’s growing nonstop. But if you only looked at their income statement, you would miss the fact that they need more investments. Your investment in OpenAI, per se, could shrink. This is simply because their cash flow statement shows that they will be spending a lot of money. They will need external investment to maintain their operations.
If they don’t get that investment, then they might be looking at bankruptcy or cost-cutting solutions. Thus, a cash flow statement in its three-statement model shows a bigger picture than what you would see from just an income statement.
That’s why investors constantly require a three-statement financial model rather than just one of those statements.
Do Startups Really Need a 3 Statement Financial Model?
When we are asked whether startups really need a three-statement model, we always recommend that they go for it. If they’re looking for a large investment, especially a seed investment before they have a Minimum Viable Product (MVP) or product-market fit, then for sure, they do not require a three-statement model.
Simply because they haven’t proven that they can earn money from this project. If you can’t earn money from this project, then why over-analyze and over-plan, thinking you will need an investment in a certain number of years?
Focus on the smaller, short-term goal of just making your first ten thousand or your first hundred thousand in the case of a startup. Only then will you be able to grasp a good investment.
The Reality of Seed Investments
Any investor who invests in a seed company is not naive enough to believe that a company will run based on initial estimates. Not a single company in this world had financial models at the seed investment stage that were actually accurate. Everyone is inaccurate because it’s too early to assess anything.
The market hasn’t seen the product yet, or it has seen it but hasn’t recognized its full potential. Any financial estimate is just a symbolic statement.
It’s a bigger picture compared to the operations that ought to happen in the long-term future.
Building Your 3 Statement Financial Model
If you’re interested in working on a three-statement financial model, I would advise you to always start with an income statement. The income statement is the root of a three-statement model.
When you work on an income statement, you learn about your financials regarding costs, expenses, and revenue-generating sources, along with the estimated amount of revenue coming out of it. You will know how much money you’re pouring in and how much money you are spending.
From this income statement, you can always create the cash flow statement. This statement shows how much cash you will have at each stage of the company over the next five years. The more you expand the number of years, the less accurate it becomes.
After you create both statements, you have the groundwork to start creating a balance sheet. This is a simple formality in my opinion, as it just shows where everything is.
Investors and Balance Sheets
Investors, especially large investors like Warren Buffett, only need to look at balance sheets to determine whether it’s a good investment.
Of course, investors like Warren Buffett usually invest in companies of the past, like carpet manufacturing companies or restaurants. In those scenarios, creating a balance sheet is essential. Looking at a balance sheet could provide a lot of information, especially for an experienced investor like him.
But for tech companies like Slack or Salesforce, it’s much different.
So, while looking at a balance sheet is important, it is not the most critical aspect at the usual stages of a startup until a company is public or makes sales by the millions.
Resources for Your 3 Statement Financial Model
Yes, we have a few financial models on our website. You can search for a financial model that includes a three-statement model, including cash flow statements, balance sheets, and income statements that you can freely use.
However, remember to conduct your market research very well before working on a financial model. Perfect it in a way that makes sense to you and your company.
That’s the only way you can work on a successful three-statement financial model.
You can always create a financial model, but if you’re looking to create a three-statement model that actually works, keep that in mind.
PS. Check some of our free templates here; You’ll find some financial models you could definitely use.