Financial Modeling Best Practices
Building a financial model from scratch can be pretty daunting, especially if you’ve never done it before. However it’s not as complicated as you might think. With a good grasp of some of the best practices and tips to follow, you can have a reasonably good model in no time.
Although each business may have its own suitable financial modeling practices, there are a few industry guidelines that are generally followed and common for all financial models.
Why do you need to adhere to the best practices?
Sticking to a certain set of rules and guidelines may feel limiting at first but in reality, most of these practices have been developed over the years to safeguard your model from errors. The key benefit, however, is how much time you can save by simply not repeating the same mistakes.
Financial Modelling Best Practices
- Plan before you start
Dealing with issues as they arise is not a good strategy where financial modelling is concerned. You need to plan well ahead so that you don’t end up over-complicating your model with unnecessary particulars. Make sure you’re on the right track by asking yourself some key questions before you set out to work on the model. They include:
The purpose of your model.
The best place to start is with a why question.
Why exactly are you building a financial model? What do you hope to achieve with it?
Defining the purpose of your model orients your entire process in the right direction. Define concrete goals. For eg: ” Forecasting sales performance in the next quarter for your online business”.
Problem-solving,
What problem do you intend to solve?
No matter what business you’re in, your model is designed to solve a mixture of unique and general problems.
Pinpoint what they are before you start.This will keep you from adding unnecessary details or spending too much time collecting irrelevant data.
The size and scale of your model
If you’re a small scale business operating online, then it is best to stick to a single worksheet as much as you can. It’ll be easier to spot errors quickly and complete the model faster.
Knowing who the end users are
Determine who else will be using your model, besides yourself and your staff. This way you can decide how streamlined it needs to be.
If you’re running a simple e-commerce business with a very minimal staff, you can avoid a lot of the overly complicated technical jargon as long as your model is easy to access for you and your team.
Make sure your model is structurally sound.
The most basic structure of any financial model is made up of certain inputs (also known as assumptions), a processing method (calculations) and outputs (outcomes).
Normally, it’s best to limit all your key inputs, assumptions and calculations to one worksheet. The more spreadsheets you create, the harder it becomes to navigate for the end-user.
Users need to be able to distinguish between areas that need manual intervention and areas where the software is used to make calculations. This is why gathering all your assumptions in one place can also help minimise a large number of errors.
Keep it simple and easy to access
It only takes half a minute for a user to decide whether a financial model is interesting enough to follow or not. Keep the number of underlying assumptions at a bare minimum (10-15). The more assumptions you make, the more complicated your model becomes and the more unrealistic your outcomes will be.
You should also try using shorter formulas. If your computations are taking really long, then you may need to rework your modelling strategy.
Use cell names sparingly.
Using too many cell names and range names might have the opposite effect of complicating your formulas as it can make your model overcrowded with way too many labels. This can in turn confuse users. It’s always best to use the same formula across rows so that it is easier to follow and interpret.
Consistency is key
Make sure your formatting is consistent. There needs to be uniformity across your fonts, labels and style. Describe your rows and columns in very clear terms to avoid confusion.
If you have more than one person working on the model, make sure that everyone is on the same page when it comes to color coding, labeling, and other formatting choices.
Add an executive summary.
Outline all your assumptions and drivers in the summary. You also need to include special references to your balance sheet, income statement and a visual representation of the cashflow.
Also consider using a table of contents with as many guidelines and instructions to help make your model easier for the user to navigate.
Ensure all statements have been integrated
Your balance sheet, income statement and cash flow calculations are the key essentials of your financial model. They need to be fully integrated so that the user is able to instantly forecast a cash flow position by using the model.
Moreover, financial modelling is about taking a holistic view of your business to see how it will perform in the future. This isn’t possible if you take statements in isolation instead of viewing them in relation to one another.
Check your model’s accuracy.
It’s highly likely that you might have repetitive rows of non-crucial data littered throughout your model. The best way to counter this is by grouping your rows. This way you can always find the data you need while also maintaining a cleaner presentation.
Double check your formulas for errors.
Most inaccuracies are a result of copying errors or incomplete data. Make sure you pay special attention while writing formulas. A single error in this case can disrupt the integrity of your entire model.
Use a standard naming convention for your files.
Try to make sure that all your files are arranged in chronological order. Also ensure that this corresponds to the alphabetical and numeric order. It is also wise not to use dates for your file names as this can lead to more confusion.
Run an auto-check regularly
If you’re using Excel software for your online business’ financial model, then it is best to run the audit function for regular error-checks. You’re more than likely to spit errors you may not have even noticed before.
Perform sanity checks from time to time
Sanity checks can help you test your model for errors. All you need to do is ask some basic questions and check the outcomes. If they don’t align with something that’s considered general knowledge or common sense, then your model may have a fundamental error you need to fix.
Get it reviewed by someone else
Get a third party to review your model. When you spend too much time on the process, it’s possible that you may be blinded or tend to overlook certain glaring obvious errors. A quick review by an external party can sort that sort that out for you. Make sure they go through your model sheet by sheet and actually test some of the outcomes.
Make it as intuitive as possible
End users aren’t very keen on going through a whole lot of guidelines before they start using the model. They’d prefer being able to intuitively use it with minimum assistance or explanation. The more elegant your formulas are and the more accurate your data is, the more effective your model can be.
Set all your variables and outcomes apart from each other
Separate the assumptions (inputs) , calculations (processing) and outcomes (outputs) in your model. Make sure that everything from the different worksheets down to the hardwired cell values are separated.
Clarity in coding, consistency in formatting.
One of the most important things any model needs yet one of the most hardest to achieve is clarity. The clearer your values and inputs are formatted, the more comfortable it becomes for the user to carry out calculations and test the model.
Make sure that your labeling is descriptive
This is super important and cannot be overlooked. When deciding on what to name certain units, it’s best to try and be as unambiguous as possible. All it takes is one misinterpretation for your projected outcomes to suffer.
Go with the standard flow.
As a general rule, the flow of a model is left to right and top to bottom. Unless there are certain worksheets that should be reviewed first on priority by the user for a better understanding, it’s best to always stick to the standard flow mentioned above.
Try to use self-explanatory column headings as much as possible. This is much easier to do when every column has a clearly defined and unique purpose. Also make sure that you don’t mix up the positioning of columns from sheet to sheet.
To summarise, these are all some of the most commonly adopted practices in building a financial model. Regardless of what e-commerce business you run, following a set of tried and tested guidelines can ensure your model functions just the way it’s designed to. And at the end of the day, that is what’s most important.
