Too often we see businesses operating with a back-of-the-envelope approach to forecasting. This article explores what a financial model is and why your business should have one.
Financial models provide answers and insights
A financial model uses a series of inputs as drivers to produce financial outputs. The outputs usually answer a question or provide insight into a problem.
Inputs are often a combination of financial and non-financial drivers e.g., sale price per unit, number of units sold. These inputs are critical to the usefulness of the outputs because we all know that “rubbish in equals rubbish out”. This mantra serves the model builder and the model user as the inputs should be designed following best practice and entered accurately.
The model calculations follow on from the inputs and provide the link to the outputs. Calculations should be separated from the inputs and clearly communicated to the user that they are not to be edited. Separating inputs and calculations provides a layer of control, reducing the risk of model tampering.
Model outputs come in all shapes and sizes as dictated by the model’s purpose. Typical outputs are detailed financial statements (income statement, balance sheet and cashflow statement) with a one-page dashboard to summarise.
Whatever form the outputs take, they should clearly answer the user’s question or provide insights into a problem. In addition to direct outputs, scenarios and sensitivities can be overlayed.
Making use of scenarios and sensitivities in a model provides the user with a range of insights. For example, entering ‘business as usual’ inputs and generating scenarios that show higher or lower growth.Graphical outputs can compare these scenarios and give greater insights immediately, showing the user a range of outcomes.
Build business confidence with a clear financial roadmap
A well-designed model produces a financial roadmap for the future by leveraging the past, giving stakeholders greater confidence in your business.
Using a model often starts with reporting and analysing business performance over recent history. This analysis can be as simple as month-on-month comparisons, or more complex such as comparing rolling last-twelve-month results against industry benchmarks. Through analysing the past, the user can draw insights and refine the model’s input assumptions.
The future is guesswork, but with assumptions driven by analysis of the past, a model will produce a roadmap that reflects reality. This includes consideration of traits such as seasonality profiling and cashflow timing. Having a realistic financial roadmap for your business allows for better planning of major spends such as capex, or of recovery from disruptions such as by COVID-19.
In addition to internal purposes, external stakeholders have greater confidence in a business with a clear financial roadmap. For example, many models are built at the request of lenders or to support a transaction. A well-built model with evidence of carefully considered input assumptions gives confidence to stakeholders that a business is in good hands.
All businesses will benefit from using a robust, long-term financial model to help guide strategy and decision making.
Best practice defines a well-built financial model
A well-built financial model should align with the 10 best practices as outlined below:
- Keep it simple and transparent
- Identify and separate inputs, calculations and outputs
- Format in a clear and consistent manner
- Use structured and descriptive labelling and units
- Keep the flow natural – left to right, top to bottom
- Use consistent column headings throughout the model
- Use one unique formula per row that is copied across
- Make extensive use of error checks
- Include table of contents, user instructions and explanations
- Avoid high risk functionality or outputs
Any model that is built in line with the principles above will stand out from the rest. This applies to a simple one-sheet workpaper as much as it applies to a complex, long-term financial model.
Build these best practice principles into your work habits and see how your work improves.