A financial model is a system or a process created to analyze the financial issues of a business or organization. A financial model is an effective way to review past performance, forecast future results and support the decision-making process. It helps provide a more clear and logical view of the organization's finances. Financial modeling is a critical financial management tool that is used by entrepreneurs, financial analysts and investors to assess the potential value of a potential investment or project.
Financial models are particularly important when it comes to understanding potential outcomes in the marketplace, assessing a company’s future performance, and making informed decisions about strategic investments. It is important to have an accurate and reliable financial model to provide a successful outcome. The following steps provide an outline of the best practices when creating an accurate financial model.
Creating an accurate financial model requires the gathering of data from respected sources and in order to execute this task effectively, certain steps need to be taken. There are primarily two components of data to focus on when starting the creation of a financial model: company specific information and market data.
Understanding Company Specific Information
The first type of data to consider when building a financial model is the company specific information. This could include past and present metrics about things like balance sheets, earnings reports, top line revenue, cash flow, and more hisotrical summary metrics. Proper research and understanding of the company's current and past financials is the basis of like-for-like analysis and forms the foundation of the financial model. This data collection step is often often the most demanding and challenging, especially for organizations that operate in more than one country due to differences in accounting standards and tax laws.
Acquiring and Understanding Market Data
The second type of data to consider when building a financial model is market data, which often consists of macroeconomic indicators, commodity prices, stock market prices, and other industry specific information. This data helps to create a baseline forecast and provides an indication of a company's relative performance when compared its peers or the market as a whole. It is important to acquire reliable and timely data that represents the company's industry correctly so that the model can provide an accurate representation of the company's performance.
Gathering data is one of the most critical steps for building an accurate financial model and understanding how the data should be collected and used is essential. Therefore, companies should be considerate when selecting the sources from which to gather the data, making sure that the data is both reliable and up to date.
Financial modeling relies heavily on analyzing and interpreting data. As such, it’s important to create a thorough data interpretation model when building a financial model. This will ensure the accuracy of the model’s results.
Examining the data collected
The data collection process involves gathering all the necessary financial information that will comprise the financial model. Once the data has been collected, it needs to be thoroughly examined. This examination should look at any potential discrepancies between the data points and see if trends can be identified. It’s important to note any discrepancies between the data points and how they may affect the validity of the model’s results.
Identifying any outliers or identifying additional data
The data collected should then be examined to identify any outliers. Outliers are pieces of data that significantly influence the results of the financial model, yet are noticeably or substantially different from the other data points. By identifying these outliers, it is possible to adjust the model to better reflect the data. Additionally, it may be necessary to identify additional data that was not initially taken into account. Doing this will provide more accurate results.
Creating an accurate financial model requires that you build a set of assumptions that accurately reflect the environment that the model will operate in. The goal in constructing these assumptions should be to ensure that the potential financial outcomes produced by the model are as close to real-world estimated outcomes as possible. The following are the steps to building assumptions.
Developing Assumptions to Account for Changes in Environment
Before building assumptions into the financial model, it is important to anticipate any changes in the environment or market conditions that could impact the outcomes of the model. This could be changes in customer capacity, changes in technology, or changes in the general economic conditions of the industry. Once changes have been anticipated, assumptions can be built into the model accordingly in order to account for these changes.
Accounting for Post-Model Outcomes
When constructing assumptions for the financial model, it is important to consider any post-model outcomes. These post-model outcomes could include changes in customer preferences, changes in employee behavior, or changes in supply costs. In order to accurately estimate the future potential financial outcomes of the model, it is important to consider potential post-model outcomes and incorporate them into the assumptions built into the model.
Building the Model
Creating a financial model involves turning quantifiable information about a potential investment or financial decision into a working tool for evaluation. Ultimately, any financial model aims to help make better financial decisions. The process for building financial models varies according to the user’s objectives and the data available.
Creating the model’s framework
The first step in building a financial model is to design the structure of the model. Typically, this involves creating an Excel spreadsheet with columns and rows and terms to represent the relevant variables. Each part of the model should correspond to the factors the user wants to study. All assumptions and formulae should be clearly explained.
Gathering the quantified data
The second step in creating a financial model is to find, quantify and input data relevant to the project. This can involve researching market trends, extracting historical data, and determining the present value and expected values of the variables. All financial projections should be realistic and sourced from reliable sources.
Populating the model
The third step is to populate the model. This involves inputting the quantified data and incorporating formulae that calculate projected costs, expected profits or rate of return according to the variables in the model. The inputs and outputs of the model should be tested to ensure that the output is accurate and reflects the inputs accurately.
Validation and Revisions
Creating an accurate financial model requires a significant amount of effort. Once the inputs and assumptions are plugged into the model, it is important to validate and review the output. It is critical to ensure it represents reality and that it is free from any errors.
Scrutinizing the assumptions
The first step in validating the model is to closely examine the input assumptions. The assumptions should be accurate and based on relevant data. If any assumptions are incorrect, they should be corrected to ensure the output data accurately reflects reality.
Checking the model for accuracy
Once the input assumptions are finalized, the model must be checked for accuracy. This includes cross-checking calculations, testing the formulas, and proofreading for mistakes. It is important to ensure that the model calculates values correctly and accurately reflects the desired scenarios.
Modeling assumptions for various scenarios
The next step is to model assumptions for different scenarios. For example, a financial model may be run with assumptions of an economic downturn so that the impact of a decrease in demand can be tested. The model needs to be consistently analyzed and tested to ensure it reflects all of the desired scenarios.
Creating an accurate financial model is essential for any business that needs to make important decisions. There are several steps that must be followed in order to ensure an accurate model. These steps include developing an appropriate scope, understanding the financial statement structure, gathering and entering data, creating the model, testing and validating the model, and then implementing the model. It is important to note that accuracy and consistency must be maintained throughout the entire process in order to ensure the most reliable results.