What Is a Financial Model?
A financial model is a representation of the expected financial performance of an organization, product or asset. It simulates the potential outcomes of decisions or scenarios by defining assumptions about the world, expected performance, and operational and financial relationships.
A financial model estimates the financial outcome of questions such as, how much money will we make this year? Is this investment a good idea? How much risk are we taking?
For further guidance on the nuances of a financial model, check out AFP’s article, Defining a Financial Model.
What Is a Financial Model Used For?
Finance professionals use financial models in an effort to quantify the future, make decisions and get stuff done. That stuff could include any of the following:
- Analyzing business strategies.
- Informing business decisions
- Identifying and measuring risks.
- Valuing risks and opportunities.
- Conducting sensitivity, scenario and stress tests.
- Measuring your compliance with internal limits, covenants or regulatory requirements.
Models aid finance professionals in planning for and analyzing the wide range of decisions they face, including investments and valuations, credit and leverage buyouts, planning and budgeting, and mergers and acquisitions. Some models may be ad hoc, built to look at unique situations, while others are highly controlled, used multiple times per day and shared widely.
With the assistance of a financial model, you can generate conclusions, alternatives and recommendations and present them to decision-makers in a way that highlights key outputs and assumptions made.
Who Builds Financial Models?
In finance, everyone builds models. When talking about sophisticated models that take days or weeks to build, it is generally the financial analysis managers or directors with their hands on the keyboard, as it takes a combination of focused time and fluency in business calculations to build a sophisticated model. CFOs will have experience having built models in the past; they may create quick models to test the logic or outcomes of what their teams build, but most CFOs will delegate heavy model building due to the time and effort required.
It is important to recognize there are several roles within the model-building process. The building of a financial model starts with the requester. This person needs to provide clear direction, time, resources and expectations of the end product.
It then moves to the support network that supplies the design, data and best practices. For example, the business is invited to provide data for the model that is consistent with its access protocols or market parameters such as elasticity; those who have built similar models (your peers in finance) can share techniques and calculations from their previous efforts.
A number of people, called validators, will give you feedback to help ensure the model meets the original objectives, adheres to best practices and does what it is meant to do. You may give them a version or read-only access so they can examine the logic or test how it works under extreme situations, without the risk of invalidating or breaking the model.
You may have a group meeting with the validators to explain the calculations and data flows. The validators should have some sort of related expertise. Perhaps they came from the support network and have business domain knowledge, they are experienced
model builders, or are the CFO with a keen interest in the outputs. You want the validators to find flaws before the model is put into practice.
What Skills Do You Need to Create a Financial Model?
Financial modeling requires a multidisciplinary skill set that includes both technical and business skills.
Financial skills: If you are building a financial model, you need to know some finance and accounting, so you can project how the decision will impact the balance sheets and income statement. Common valuation/decision techniques you should know include NPV, IRR, ROI and break-even analysis. Common accounting practices you should know include modeling cash flows and accrual-based flows.
Business skills: This is the context that explains the financials. You need to be able to answer questions such as, how does the business make money? What is the competitive landscape? What are the company objectives and goals?
Technical skills: You need to merge two types of technical skills. One is the knowledge of your tools, whether that is a spreadsheet, an enterprise performance management tool or something else. The second is the ins and outs of model design, data flow, and how to create an engaging presentation of the model output. The scope of the model will drive some of the specifics on what you need to know.
Partnership skills: The goal of your model is to tell a story. When you succeed in telling a story, you also set the wheels in motion to achieve credibility and inspire confidence in the reader, thereby increasing buy-in and securing
your impact on future decisions.
How Do You Build a Financial Model?
Many financial professionals use spreadsheets, e.g., Excel, to build financial models, but technological advancements and the growing intuitiveness of tools such as BI products or ERP forecasting modules offer additional options and functionality. Regardless of your tool, there are four phases to consider when developing the model:
1. Plan the Model
Don’t just sit down and start pounding away on your keyboard; start with your purpose. Determine what you want to analyze, forecast or evaluate. What questions do you want the model to answer? Models are built for specific reasons and applying them to the wrong jobs can be disastrous! Be sure to document why your model exists and what it should do.
- Understand and document the desired outputs for the model. Models need to deliver on their stated goals, such as informing and driving types of decisions. Get this IN WRITING! Understand when a model is being applied beyond its intended use. Simplicity is key to strong, transparent models that are understandable by multiple users.
- Figure out who your stakeholders are and what they need. Examine the context, both strategic and as it relates to the business unit operating plan. Figure out the scope and set your deadline. Then you need to drill down to define the required outputs, and at the same time, take the time to really understand their constraints.
- Define key inputs and the input-to-output logic. What this refers to is figuring out the types of inputs, such as direct, contextual or derived, and differentiating between the direct and contextual inputs. Then you will need to specify the value drivers and related KPIs, both external and internal. Finally, be sure to document the logical flow of both inputs and outputs.
2. Get Your Data Right
First, understand what data is required to build your model and that it is of sufficient quality to run your calculations. You may find gaps in your data that you need to fill! Second, consider your data governance. That is, your model needs a plan that ensures trusted data is secure and easily accessible throughout its lifecycle, from sourcing through various transformations to usage in a model (or reporting).
3. Build the Model
This is the phase where you build the skeleton for your model. A well-built model is also a usable model, which means it can flex and respond to users’ needs as they seek to refine and customize it.
- Simplicity is key to strong, transparent models that are understandable by multiple users.
- Distinguish among data, assumptions and variables.
- Identify gaps and unknowns that you will tackle through continued refinement. In the meantime, look for missing information and/or use proxies and assumptions.
4. Iterate on the Model
There are several opportunities for you to get feedback on the model, including from the requestor and peers who will conduct quality control and validate your work.
Don’t start by building the perfect model. Spend a SHORT amount of time building a prototype and then share this with the requestor to make sure you are directionally correct, will achieve the purpose, and have surfaced some nuance and challenges
in the data and calculations. This will save you hours or even days of effort.
Get a more detailed look at each of the steps in AFP’s article, 4 Steps to Getting the Information You Need to Build a Financial Model.
Financial Modeling Best Practices
Consider these four financial modeling best practices for a more agile process.
1. Deliver According to the Goal
Don’t try to build a single module that explains everything in the universe; models need to deliver on their stated goals, and adding complexity makes them harder to use and understand and rarely improves utility (accuracy). You are building your model for a reason, so deliver on that!
2. Work Closely With Your Partners
Always keep the end user in mind when you’re building a model. Have end users in the loop throughout the model development process. As part of this process, you will likely need to iterate. Repeating steps, whether one step or the entire process, is simply part of the development process.
3. Build Flexible Models That Accept Changes
A well-designed model compartmentalizes inputs, calculations and outputs; has document flows; and uses standard calculations. This allows the model to absorb changes rather than breaking or requiring extensive changes.
Incremental delivery, mid-project testing and design “sprints” through modular build and delivery can reduce error by providing intermediate risk and control points.
4. Institutionalize Excellence
Good design and governance will pay off in flexible, adaptable models with fewer errors. Be sure you have governance and risk management practices in place for every stage of the model lifecycle.
Learn more about Financial Modeling Best Practices.
Common Types of Financial Models
Financial models that are most commonly used in financial planning & analysis include:
Three-Statement Financials. A type of model that produces an expected income statement, balance sheet and cash flow (sometimes called a pro forma). It is used to see the holistic impact or expectation of a company.
Discounted Cash Flow (DCF). This is a valuation analysis model that estimates today’s value of future expected cash flows of an investment, decision, asset or operation.
Consolidation. As you might guess, this model combines the financials of multiple business units into one single entity. The finance arms in disparate parts of the company will develop their unit models, then submit them to the corporate FP&A team for consolidation.
Budget. The aspirational plan of performance, this model is often used for setting corporate and divisional targets and spending allocations on the way to meeting overall goals and objectives. It is often the first year of a strategic plan.
Forecasting. The best, realistic estimate of expected performance based on historical information, the current situation and expected actions.
Sum of the Parts (SOTP). This model allows the builder to determine what their company’s individual business units would be worth if they were “spun off,” i.e., purchased by another entity.
How Can You Learn Financial Modeling?
Check out these resources to learn more about financial modeling:
- AFP Guide to Financial Modeling and Model Supervision
- Financial Modeling and the Executive Suite
- Five Scenario Modeling Methods for Better Forecasting
Watch the videos in our AFP Quick Study Tools series to learn:
- How to use Excel to build a rolling forecast.
- How to run Monte Carlo simulations in Excel.
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