Introduction
In today's business environment, accuracy and reliability when making long-term decisions are essential. Three-Way Financial Modelling (TWM) is a key tool that can help companies assess the impact of these decisions. This blog post will take a look at the best practices for developing and maintaining a Three-Way Financial Model.
Definition of Three-Way Financial Modelling
TWM is a type of financial modelling that considers the impact of a variety of factors, such as a company's operations, financial structure and capital expenditures, on its current and future financial performance. It involves creating a complex spreadsheet-based financial model composed of past, present, and future financial data that is used to project a company's annual income, cash flow and economic value.
Objective of Three-Way Financial Modelling
The primary objective of TWM is to enable a company to make more informed decisions by providing an accurate, detailed, and predictive analysis of a company's financial performance. This helps companies to evaluate various scenarios, plan for the future, and make more profitable business decisions.
Benefits of Three-Way Financial Modelling
- TWM provides companies with detailed understanding of the past, present, and future financial performance.
- It can help companies identify potential risks and opportunities.
- It can be used to forecast cash flows, assess the impact of changes in operations, and provide guidance for future operations based on past performance.
- It helps companies make well-informed decisions about financing and investing.
- It helps companies to create accurate budgets and plan for the future.
Key Takeaways
- TWM provides detailed understanding of the past, present, and future financial performance.
- It helps companies identify potential risks and opportunities.
- It can be used to forecast cash flows, assess the impact of changes in operations, and provide guidance for future operations based on past performance.
- It helps companies to make well-informed decisions about financing and investing.
- It helps companies to create accurate budgets and plan for the future.
Essential Components of a Three-Way Financial Model
A three-way financial model is a comprehensive tool used to outcome outcomes of a business. It provides a hierarchical and comprehensive way of evaluating forecasted data based on three primary components which are incorporated into both short and long-term financial modelling. The essential components of a three-way financial model are the income statement, balance sheet, and cash flow statement.
Income Statement
The income statement is the core component of the three-way financial model. It gives a summarised view of a company’s revenues, costs and other related expenses. The income statement usually contains three important sections: revenue, cost of goods sold and operating and nonoperating expenses. Income statements are usually compared over a span of at least two consecutive accounting periods.
Balance Sheet
The balance sheet is another key component of the three-way financial model. It is composed of the assets, liabilities and equity of the business. This component will give a snapshot of the overall financial position of the company at the time of the statement. The balance sheet also provides an indicator of the company’s financial strength by assessing the debt/equity ratio.
Cash Flow Statement
The cash flow statement is the third primary component of the three-way financial model. This statement details all of the company’s cash inflows and outflows over a given period of time. It is important to note that cash flow statements include cash flows from all sources, including operating activities, investing activities, and financing activities. This statement helps to assess the current and potential financial positions of a company.
Establishing Three-Way Financial Modelling Principles
A Three-Way Financial Model is an important tool that helps businesses to make informed decisions about their finances. Developing and maintaining a successful model requires appropriate principles that are applied with the utmost attention to accuracy.
Define Assumptions Used
The success of a Three-Way Financial Model hinges on clearly defined assumptions upon which the model is built. Those assumptions should take into account past, present, and future fluctuations in the relevant market and should be updated regularly. It is essential to understand the impacts of competing assumptions on the model and to apply only those that are relevant to the particular situation.
Understand How All Assumptions Interconnect
For a Three-Way Financial Model to be successful, the assumptions used must all interconnect in a manner that provides the most reliable information. It is important to understand how fluctuations in one assumption may lead to changes in another. It is also crucial to consider the implications of different scenarios and to adjust assumptions accordingly. This can help to ensure a successful model.
Ensure Accuracy Of Inputs To Preserve Results Accuracy
The success of a Three-Way Financial Model is dependent on accuracy. All inputs to the model must be carefully checked for accuracy to ensure that the results are reliable. This includes verifying that the assumptions used are valid, ensuring that all numbers are entered correctly, and double-checking that all calculations are accurate. Taking the time to ensure accuracy of inputs and calculations will pay off in the long run.
Calculations and Calculating Systems
When developing and maintaining a three-way financial model, there are several key factors to consider with regards to calculations and calculating systems. Utilizing the correct formulae and algorithms and automating the calculations for speed and accuracy are essential for streamlining the modeling process.
Develop algorithms to establish interconnectivity of assumptions
When building a multi-dimensional financial model, the assumptions and their consequent calculations must work interdependently. This means understanding how to embed the assumptions into specific algorithms which detail the flow of information, calculations, and output. It is necessary to spend due time preparing these algorithms prior to entering assumptions in the model. Doing this will greatly reduce errors and alleviate stress down the line.
Utilize formulae to calculate new assumptions based on historical inputs
Formulae are the backbone of a financial model, as they are the basis for calculating new assumptions based on historical inputs. Having the correct formulae in the model will ensure reliable and consistent calculation outputs. Generally speaking, having more complex formulas for more complex calculations is the better approach.
Automate calculations for speed and accuracy
Automating calculations in a three-way financial model will significantly expedite the modeling process as well as result in greater accuracy. Automation diminishes the risk of errors, thereby decreasing re-work time and increases confidence in the output. Furthermore, automated calculations allow for quicker and more frequent updating, continuing to enable better results.
By developing the right algorithms, utilizing formulae, and automating calculations, a three-way financial model can be accurately and efficiently maintained and developed. Doing so will result in a trustworthy model that will ensure reliable, timely results.
Documentation
Developing and maintaining a three-way financial model requires thorough knowledge of financial concepts, along with proper documentation. Documentation helps keep track of the assumptions used and calculation systems, to ensure consistent and accurate models. Here are some of the best practices for developing and maintaining an effective documentation system.
Record Assumptions Used
It is important to document the assumptions used in the model, such as the data used for calculations and forecasts, the assumptions behind the assumptions, the sources of information, any assumptions made, and any models or scenarios employed.
Document Formulae for Calculation Systems
Calculation systems are a vital part of the three-way financial model and require careful documentation. Every formula should be documented, and the logic behind them should be explained. This will ensure that all calculations are accurate and consistent.
Assign Version Control for Model Updates
Model updates should always be tracked and dated through a version control system. This will help to ensure that any differences between versions are clearly identified and that any changes are clearly documented. This will also make it easier to track any changes over time, enabling more accurate analysis.
- Record assumptions used
- Document formulae for calculation systems
- Assign version control for model updates
6. Use Caution when Modeling
When developing and maintaining a three-way financial model, it's important to use caution. This means confirming assumptions made with reliable data, verifying all calculations, and testing different scenarios.
a. Confirm assumptions with reliable data
Before creating any financial model, it is essential to gather reliable data and confirm assumptions. This data can be gathered from sources such as regulatory updates, market trends and research reports. Confirming these assumptions will ensure the accuracy of your three-way model.
b. Verify all calculations
Once data has been gathered and assumptions have been confirmed, it is important to verify all calculations made within the three-way model. This verification process should include a double-check of formulas, formulas pathways and interest rate calculations. This will ensure that all variables within the financial model is accurate.
c. Test different scenarios
Testing different scenarios is a great way to validate the accuracy of a three-way model. This involves running different calculations and seeing how it will affect the model as a whole. This could include altering variables such as market conditions or revenue projections. This process will ensure that the three-way model is responsive to different market and revenue changes.
Conclusion
This blog post has outlined the best practices managers and finance professionals must follow when developing and maintaining a three-way financial model. Creating and maintaining an accurate and reliable three-way financial model is an important step in a company’s financial planning and management, as it provides key insights into the company’s financial position and performance. By following the best practices discussed above, managers and finance professionals can create and maintain a three-way financial model that will be beneficial for the company.
The primary objective of creating a three-way financial model is to provide an accurate and comprehensive view of the company’s financial position and performance. The model should be based on a complete set of financial statements, such as the balance sheet, income statement, and cash flow statement, and should also include an analysis of the company’s financial performance over time. Furthermore, the model should be monitored and adjusted regularly to account for any changes in the company’s performance and financial position. By following these best practices, finance professionals and managers can ensure the accuracy and reliability of the model.
The benefits of developing and maintaining a three-way financial model include a better understanding of the company’s financial position and performance, improved financial planning and management, and enhanced investment decisions. By using a three-way financial model, managers and finance professionals can make informed decisions about the allocation of resources, capital investments, and other financial matters.
In conclusion, creating a three-way financial model and maintaining it according to best practices is an important step in accounting and finance. Following the best practices outlined above will help ensure that the model is reliable and accurate, and that the company is able to capitalize on the many benefits a three-way financial model offers.