This article was written by Ben R. and is the opinion of the author.

Founders and investors need financial models that are transparent and easy to understand. We know how to draw a hockey stick, this is the term used to describe the huge and inevitable rise in revenues expected by startups over time, but it is how we get there that matters. The most common mistake I see in financial models for new ventures is a failure to adequately show the inputs that drive the model, especially in manufacturing.

Identify The Unit Of Value

When I was a stock analyst on Wall Street, I had a friend who for two years in a row generated over 50 percent of the profit on a trading floor at a big investment bank. While his success impressed me, I was more impressed by the way he talked about his trades. No matter how complex, he could summarize a trade on the back of a napkin using simple math.

As an equity analyst, I used Excel, not napkins, to model my assumptions and forecast financial performance for listed companies. These models were useful but some were so complex that even I could get lost in the lines. My friend taught me to identify and focus on the basic units that matter as a way to master complexity.

When I entered private equity, a boutique investment bank brought me on board to write the business plan for a soon-to-be-funded biodiesel manufacturing business called Fuel Bio. When I interviewed the founder and future CEO of Fuel Bio, I learned that the energy business is complex due to technology and a vast array of regulatory schemes. Our CEO had a million ideas about how to make money in the emerging field of renewable energy, but my model began with a single gallon of biodiesel fuel.

Start With Your Assumptions

In my model for Fuel Bio, I first identified my assumptions for the biodiesel inputs, which included soybean oil, methanol, and caustic soda. Each of these has a cost per unit and a certain number of units are required to make a gallon of fuel. The difference between the sales price of a gallon and the cost of inputs required to make a gallon, is known as the crush margin, a term borrowed from the oil seed crushing industry.

Unit costs were then identified so that we could see what our assumptions were versus historical norms and possible future scenarios. At the time when I was making my model, I assumed the price per pound for soybean oil would range from $0.25 to $0.30 a pound, the high end of the historical range on the Chicago Mercantile Exchange. Likewise, I expected a gallon of No. 2 heating oil, the comparable for biodiesel and a New York Mercantile Exchange traded commodity, would be in a range of $2.50 to $3.00 per gallon.

Added to the crush margin was a $1 per gallon tax credit for each gallon of biodiesel fuel that was made with virgin seed or bean oil and blended with No. 2 heating oil, a provision of the American Jobs Creation Act of 2004. Additional items included the Small Producers Tax Credit of $0.10 per gallon, part of the Energy Policy Act of 2005, and sales of glycerin, a bi-product of biodiesel manufacturing. All in all, my model forecast a crush margin of $0.20-0.60 per gallon, with EBITDA (earnings before income, taxes, depreciation, and amortization) break-even at $0.11 per gallon.

Working Capital & Capital Requirements

The cash cycle and working capital determine how much cash is required to support growth. Fuel Bio had no credit, which meant we had to pay on delivery for soybean oil and other materials to make biodiesel. With nameplate capacity of 50 million gallons, I assumed the company would make about 1 million gallons of fuel per week at a cost of $2-3 million.

In year one, I estimated the total working capital requirement at about $8 million. This included $2-3 million in inventory plus $5-6 million in receivables, based on payment terms of 15 days. I also anticipated that the company would seek to hedge future production and sales for 6-9 months, a strategy that would lock in our margins but required an additional $15-20 million, assuming annual production of around 40 million gallons.

What Really Happened

As CFO of Fuel Bio, I got to live with the model that I produced for investors. Those in the biodiesel industry will remember that Renewable Energy Group (NADAQ: REGI) first filed for a $150 million IPO in late 2007, but withdrew the IPO in 2008 when market conditions changed. While I had predicted soybean oil prices on the high end of historical norms at $0.25-0.30 a pound, prices instead spiked to a record high of nearly $0.70 a pound, driven by the increase in biodiesel capacity and the $1 per gallon tax credit.

At Fuel Bio, we produced and sold when we could at our EBITDA break-even price of $0.11 per gallon, but we never reached the point where we could hedge and get bank financing. According to the National Biodiesel Board, US biodiesel production rose to 700 million gallons in 2008, and then fell to 315 million gallons by 2010, down by more than 50 percent. Production then recovered with the expansion of the Renewable Fuel Standard to include diesel fuel, a provision of the Energy Independence and Security Act of 2007, which drove annual US biodiesel production to more than 1 billion gallons a year beginning in 2011.

Good businesses are driven by good business models, which are about strategy and not the same as financial models. People develop business strategy and financial models help us to understand the sensitivity of our strategy to the variables that drive profit. In this way, financial models are valuable tool for understanding and managing a business.

The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.