Keys to Financial Modeling
There are many forms of a financial model ranging from a simple spreadsheet to a complex, multi-tab model with multiple years, lines of business, and scenarios. There are many advantages to financial modeling. More tactically, here are three things that can make a model most effective.
Inevitably there will be many iterations of a model, with multiple versions and scenarios. Assumptions will constantly change which will in turn change the key outputs. The main thing here is to construct your model in a way to give you maximum flexibility. One way to prepare for this is to have an outline of the model that quickly allows you to organize sections/tabs around summaries, assumptions, forecasts, products, etc. in consistent formats. This makes it easier to add/tweak areas over time. A second way is to ensure all your key assumptions are dynamic, linked, and easily accessible. This allows you to make a change in one place and have it flow through the entire model vs. hard coding assumptions within cells that are difficult to find and update. Another simple trick is to color text for assumptions different than calculations so they stand out.
Another key is to test sensitivity and scenarios in your model. We all know that any forecast will inherently be wrong! You want to be able to run some quick scenarios on key assumptions to see how output varies if you are up/down on assumptions by 5/10/20%, etc. Data tables in Excel are great ways to quickly see this and figure out which assumptions really matter. Another approach here is to also create different scenarios in the model (i.e. conservative, base, aggressive) that allow you to see things like break-even analysis and “what you would have to believe” that get you more confidence in your assumptions and the range of possible outcomes.
You can have the perfect model, but sometimes it is easy to get lost in all the details. Always remember to have a summary page that links to all the key answers/outputs needed. It allows an executive/investor/advisor to go to one place and see what they need. It is also important to translate all the numbers and summary into a “so-what.” Based on the model and analysis, we should do X. Remember, a model is used to help make decisions so be clear what the implications are on that decision.
Financial modeling is helpful from a startup to mature businesses, but always remember to keep the bigger picture purpose in mind and construct your model to easily flow with the inevitable changes.