Financial models are an integral part of every business. They are depictions of finances that aid in the strategic decision-making process. Thus, their structure and design should reflect the perfect picture of finances. That said, management relies on financial models to make strategic decisions. However, while preparing models, one should abide by certain practices. The core focus should be on organization and structure. After all, these are essential aspects of a seamless model.
This article elucidates the best practices of financial modeling for novices and pros alike. Follow them to create an impeccable model that is easy to comprehend.
Planning: Vital Step of Every Model
We are starting our list with a crucial step: planning. It is an inextricable step of financial modeling. Neglecting this step results in an error-prone model. Thus, curate a blueprint of a model to save yourself from inescapable errors. Conversely, unstructured planning subverts your model. Devote a maximum amount of time to the planning phase. During your planning phase, clarify the intended goal. With the end goal in your mind, you can create an optimal structure. Present your plan before stakeholders and get their feedback. A short meeting with stakeholders will enable you to develop a model inclusive of their preferences. It is advisable to work with clients closely to avoid inevitable issues.
- Ask quality questions to yourself.
- What financial problem is this model aimed to resolve?
- Who are the users?
- How do they plan to use this model?
The above questions are adequate to build a solid foundation for the financial model.
Structure: Pivotal toward attaining High-Quality
Integrity and clarity should be of utmost importance in the structure of a financial model. The best strategy to determine the layout is to assess its granularity. A granular model is a detailed model with multiple sheets and complex formulas. Practically speaking, precise models are ambiguous and have a high risk of errors. Before crafting a financial model, one must be familiar with the nuances. Intricate details help you to create a perfect model.
Ideally, a well-structured model includes assumptions, calculations, outputs, and sensitivities. The financial model depicts three financial statements( income statement, balance sheet, and cash flow), ratio analysis, and dashboard. The structure of the model should segregate inputs from calculations and outputs. Model processing should be accurate and optimal. Transparency makes tracking audit trails easy. It also allows users to locate any information quickly.
It is essential to apply the same layout throughout the model to maintain clarity. The structure of the model must present deliverables that are easy to digest. Lastly, a robust model should represent reality with past performance and forecasted performance.
Simplicity: an Essential Aspect
Effective models reflect finances in an easy-to-follow manner. Such models communicate figures. The key to attaining such an impeccable structure is to apply simplicity. A simple model is easy to comprehend, while a highly complex model is hard to decode. While building a model, one must know that not all users are familiar with finance. Some of them might belong to other fields. The best practice is to build a simple model so that people can easily walk through sheets within a short span. To acquire clarity, never limit assumptions to 15, and keep formulas short to avoid ambiguity. Complicated calculations make spreadsheets tedious and increase the risk of error. This approach will augment the number of rows in a spreadsheet, but it will be easy for users to comprehend and for third parties to audit.
Consistency: Extremely Important Approach
Consistency is a broad topic. A financial model demands uniform structure, formulas, color scheme, and approach. As a financial modeler, you must adhere to a consistent method throughout your model. Inconsistencies are problematic and cause issues in the model. For instance, some people prefer name ranges, while others go for references. A financial model with both name range and name references confuses users. Hence, it is advisable to select one method to avoid ambiguity.
Similarly, consistent use of color is also one of the best practices.
The below table elucidates the color scheme:
| Types | Colors |
| References to external files | Red |
| Assumptions, Inputs and drivers | Blue |
| References to other worksheets | Green |
| Formulas | Black |
In a Nutshell
Financial models without scrutinization are susceptible to errors. Thus, it is necessary to incorporate relevant practices to minimize inaccuracies. This guide is a complete framework for the best financial model.
This Article is written by SORATH FARMAN
LEXICON i best institute for Financial Modeling Training, we are providing open, corporate in-house and online trainings on Financial Modeling, IFRS, Certified CFO, Advanced Excel, Data Analysis in Power BI
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