Why Build a Financial Model?
Financial models are tools that aid in a company’s decision-making. These decisions are usually around whether a company should invest in a business, asset, or security, whether to finance a project or not, conduct a merger and acquisition, raise capital and other corporate finance transactions. Financial models are useful for every business.
The financial model enables decision-makers to examine prospective consequences, test several scenarios, and ideally, come to an informed decision using data.
It is important to note that when building a financial model, there are three skills that are essential for a good modeler to have. These skills include:
- Basic finance and accounting knowledge,
- Excel skills; and
- Basic design skills to enable you present your results in a clear manner.
Financial Modelling Best Practices
In building financial models, there are some guidelines that should be followed to ensure good outcomes for the financial model. Some of the best practices for structuring a financial model include:
- Clearly distinguish the assumptions or drivers from the rest of the model
- Use colour-coding, that is assorted colours, to differentiate between inputs and formulas
- Use clear headers and sub-headers to differentiate between different sections
- Put in error checks (e.g., balance sheet check) to track and maintain the integrity of the model
- Avoid linking to other excel workbooks
- Tables, charts, and graphs should be used to summarize valuable information
- It is also best to avoid circular references, that is when two values reference each other
Financial modelling assumptions play an especially vital role in forecasting financial data. It is good to note that financial models are built on a set of assumptions and a model is only as good as the assumptions we generate. Some of the ways assumptions can be generated include:
You can make your assumptions based on the previous results of other similar companies. It is a plus that open data is increasingly available that you can compare with your assumptions. For example, you can leverage annual reports of different companies in the industry you are considering. Gather as much information as you can, and consider how the product, strategy, stage, etc. of another company or person can inform your own (and how your experience will differ). Use that information to benchmark your assumptions.
If you have historical performance data, you can add more data points to your forward-looking assumptions. It does not provide exact answers because future performance may differ from past performance, but it is one data point to help you ground your assumptions. It also assists you in determining which metrics in your business may need to be altered to achieve a significant improvement in performance.
Linking the Statements
Once the assumptions to build the financial model are in place, the majority of the work has been done. We are left with a bunch of mathematical calculations to arrive at the result. The steps in building the model and linking the statements include:
- Start by computing revenue based on the assumptions generated as explained in the previous section. After this is done, you can calculate the other costs because most of the other line items are based on the revenue generated.
- Create supporting schedules for working capital, fixed assets, and financing (debts)
- Finish building the income statement and balance sheet after completing the calculations. Note that cash should not be included yet on the balance sheet as it is the last part of the financial model to be completed.
- Build the cashflows statement consisting of operating, investing, and financing activities. This will be linked from the completed income statement and balance sheet. It is after the cash flow statement has been completed that the cash balance can be included in the balance sheet.
With the financial model in place, we can decide the additional things we want to create. Some of the other analysis that could be done with the completed financial model include financial ratios, DCF valuation, market valuation, and sensitivity analysis.
Presentation of Results
After conducting the analyses outlined above, the work is not over. The final stage is to communicate the results of the model in a simple and comprehensive manner. This is typically done via a dashboard of charts, tables, and other graphics. The design skills we spoke about earlier are critical here.
Building a robust model that no one else can use or understand is futile. Analysts must put the objectives and needs of management and other stakeholders at the heart of financial modelling. It is only then, that models can fulfil the role of supporting decision-making.
At Leonine, we prioritise empowering businesses through proven industry standards and processes to maximise value on all fronts. For enquiries and consultation, you can reach out to us at email@example.com. We will be more than happy to have your financial model worries attended to.
Abdulsamod Balogun leads Communications and Public Relations at Leonine Investment Services Limited. He's excited about new media, technology and public policy. When he's not working, he's catching up on movies and books.