Financial Model: What is it and how do I make one?
Generally speaking, a Financial Model is an abstract representation of a business’ performance, forecasted into the future. Using a set of assumptions, business metrics, accounting records and external variables – all linked to each other within an Excel spreadsheet – a well-constructed Financial Model can provide a comprehensive insight of how well a company is doing and what variables are involved in its performance.
A Financial Model can have different purposes, and should be structured accordingly. It represents a very powerful tool to help you make informed and conscious decisions about your business. Moreover, investors will most likely expect to see a financial Model of your company so that they can understand the underlying dynamics that impact your overall profitability.
“What do I need before I start?”
Before you start working on your Model, you need to have complete clarity about three main aspects: the Model’s purpose, its audience and the people who are ultimately going to use it to make decisions.
Depending on your company’s business model, industry and development stage, a Model’s purpose should be specific. At an early stage, a Financial Model is likely to be used as a cash flow forecast that can give you an idea of when you will become profitable, or to understand the impact of different types of funding coming into your business. At later stages, a Financial Model can be use to evaluate the outcomes of M&As, new significant projects and investment.
The Model needs to be tailored around its audience. Apart from numbers and formulas, it should include accurate and meaningful visualisations of relevant data that make it as easy as possible – for whom it is addressed – to get the most information out of it with minimal effort.
Finally, all formulas must be understandable (or clearly explained through comments) to everyone who is going to use it in the future. You should implement an error check system to make it as easy as possible to spot accidental mistakes before they impact projections and other data down the line.
“What does a good Financial Model look like?”
Every Financial Model has to include, at the very least, full financial statements (income statement, balance sheet and cash flow forecast). These have to be in line with accounting standards and linked to each other so that they are all simultaneously updated if input data changes.
A good Model needs to be simple. Don’t use excessively long formulas, show every step and make sure that the whole process looks smooth to an external user, from input to results. This will also help spot possible errors and save you time in the long term.
All the data you put into the Model needs to be as accurate as possible. This includes input data such as past financial statements, sales data and other business metrics, and also assumptions. Try not to be bullish in your assumptions, and gather as much information as possible before you estimate uncertain factors. By nature, assumptions are risky, so it is important that you try to reduce this risk as much as you can so that your forecasts are more reliable.
The main purpose of a Financial Model is to project and forecast your company’s performance. These forecasts will have a critical impact on crucial decisions, so it’s important that they are realistic. Always take into account error margins and possibly analyse the sensitivity of your future performance to changes in your assumptions.
As Financial Modeling takes time and hard work, it is in your best interest that your Model is flexible enough to be used again in the future and updated with new data or for different purposes.
How you present your Financial Model is also crucial to your audience’s understanding of it. Make sure you use consistent formatting that highlights key information and helps distinguish different kinds of data throughout the spreadsheet. Finally, consider including an introductory instruction page that outlines the basic functioning of your Model, to make it easier for future users to consult and work with it.
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“How do I know if my Model is working?”
There’s no easy way to test a Model, apart from checking it against reality after it has been produced.
You can only take precautions in order to make the Model less likely to be reliant on wrong assumptions, ineffective in communicating its messages or not relevant to its purpose.
Get a peer, a friend or an expert to proof your Model and get feedback on both accuracy and consistency. If possible, test it with someone who is going to use it in the future in order to understand what their possible concerns and difficulties might be. Check every single formula to make sure there are no calculation errors that could potentially affect your whole Model.
Finally, as with everything, practice and experience are a crucial asset in the “art” of Financial Modelling. If you don’t feel like you have the specific skillset or knowledge to prepare one, get a trained professional to do it for you. Whether you are about to make important decisions on your business, you are fundraising or you are preparing for M&A activity of any kind, an accurate and effective Financial Model can make a real difference in your company’s performance.