All You Need to Know About Financial Modeling Best Practices
Financial models have evolved from abstract spreadsheets to real-world applications, becoming an inseparable aspect of corporate life and an essential part of any company’s arsenal. Regardless of its pervasiveness as a productivity and decision-making tool, many people have a love-hate relationship with it. Financial Modeling Best Practices are an essential component of every company’s finance toolset. They are spreadsheets that detail a company’s past financial data, anticipate its future financial performance, and evaluate its risk and return profile. Financial models are often built on three accounting financial statements: income statement, balance sheet, and cash flow statement.
The exercises involved in creating an abstract representation (a model) of a real-world financial situation are known as Financial Modeling Best Practices. This is a mathematical model that is intended to reflect (in a simplified form) the performance of a financial asset or portfolio of a business, project, or other investment. Typically, Financial Modeling Best Practices are considered quantitative exercises in asset pricing or corporate finance. It entails converting a collection of hypotheses concerning market or agent behavior into numerical forecasts. At the same time, “Financial Modeling Best Practices” is a broad phrase that signifies different things to different people; it generally refers to either accounting and corporate finance applications or quantitative finance applications.
A financial model is a vital component of every company and firm. Using a financial model template might alleviate some of the burdens of creating one, but creating one in Excel can be difficult. It takes time to set up your formulae and condition constraints. A financial model is a tool that assists companies in forecasting their financial future. Financial Modeling Best Practices are often performed in spreadsheet software like Excel or Google Sheets.
List of Financial Modeling Best Practices
This article provides a step-by-step tutorial for novice and intermediate finance professionals who want to develop Financial Modeling Best Practices like an expert. This post will also highlight a selection of expert-level ideas and hacks to improve time, output, and modeling efficacy for advanced financial modellers.
Designing Your Model Plan
The first stage of Financial Modeling Best Practices, like other complex things, is meticulously sketching out a blueprint. Unexpected structural changes in the middle of a modeling exercise can be time-consuming, perplexing, and error-prone, especially if the model’s adapter is different from its creator. Such obstacles are readily overcome with a bit of forethought at the start of the workout. It is recommended that you organize your planning process as follows:
Determine the Model’s Ultimate Aim.
The objective of a model must be clearly defined to determine its ideal architecture, structure, and end outputs. Take the time, as part of this process, to verify that your model’s key stakeholders sign off on your blueprint and process design before beginning to develop. This allows them to express any final preferences or goals, preventing any “scope creep” (business jargon) or uncomfortable redirection down the line.
Understand the Timetables for the Model’s Construction and Useful Life.
Understanding the deadlines for developing the model and how long the model will be utilized are also key factors in selecting the method for the modeling process, but secondary to the model’s final aim. Long-duration and long-tenured (useful-life) models are often custom-built from the ground up and incorporate massive quantities of operational detail, flexibility, and sensitivity capabilities. Modelers may frequently employ premade templates for more immediate, shorter-duration operating or capital-project models to enhance the speed of production while avoiding mistakes. Furthermore, model templates are more familiar, making them easier to use/manipulate by many stakeholders inside businesses.
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Organizing Your Model
At this point, we’re ready to open Excel and start thinking about structure. Every model can/should be separated into three components at the most basic level: (a) inputs/drivers, (b) computations (projected financial statements), and (c) outputs. The better one segregates these portions, the easier it is to audit and change the model while avoiding mistakes and optimizing time.
The same structural approach has been used for nearly every model that was earlier created; a process that both my stakeholders and I found to be practical, consumable, and ultimately beneficial. It is dissected into the following sections:
- Cover Page (Tab): Project code name, description of the model’s intent, contact information for the creator, and any necessary disclaimers.
- Inputs and assumptions are listed on the Drivers tab.
- Calculations (Model Tab) (i.e., the three financial statement projections and calculations).
- Outputs Tab: A tidy, crisp overview of the model’s most essential highlights.
- Sensitivities Tab: The variety of scenarios, sensitivities, and data outputs on which management will rely as they progress through their decision-making process.
Let’s go one level deeper into each of these topics one by one. As an example:
The cover page is your work’s initial point of contact. While it is the easiest to construct, when done effectively, it makes an excellent first impression and indicates what is to follow. A straightforward, informative cover page is usually the best strategy, and it often comprises the following sections:
Model Name: The model’s name should be self-explanatory.
Model Purpose: A paragraph stating its intended application.
Model Index: A quick table outlining the description and function of each tab. This part is very useful for non-finance operators, as it highlights which tabs they should utilize for inputs, which outputs to focus on during decision-making, and which difficult calculation tabs they should leave alone.
History of Model Versions: Investing a few seconds in entering the main changes made to the model as you go saves time afterward, especially if you need to backtrack and reverse/modify modifications. This is especially true for sophisticated models and models that may be used as templates in the future.
Contact Information for the Author: Self-explanatory
Legal Disclaimers (where applicable, as advised by your Legal Counsel): Self-explanatory
Please keep in mind that the cover page should always be restricted to anybody and everyone who does not have specific permission to make modifications.
Inputs and Assumptions on the Driver’s Tab
The drivers (inputs) tab must come immediately after the model’s cover page. Because this is the tab that non-finance operators would most likely change, you must ensure that it is clear, succinct, and easy to comprehend. It generally advocates creating two input sections within the inputs tab, one for static and one for dynamic inputs. Static inputs are those that do not vary over time, such as the hypothetical “size of a power plant” or “a company’s initial debt level,” whereas dynamic inputs are those that change with time, such as “inflation” assumptions, “cost of debt,” or “revenue growth” assumptions.
It is recommended that you separate your data into two types within both the static vs. dynamic input sections: (a) hard-coded figures that do not change regardless of the assumption scenario and (b) sensitizing parameters that will drive different assumption scenarios and ultimately your sensitivity tables. However, until the final stages of the project, you will never know which parameters will be sensitivity parameters and which will not. Please see our post on IIM SKILLS for more information on sensitivity analysis.
Model Tab: Extensive Calculations and Operating Setup
The tab is the model’s core, where all of the inputs, assumptions, and scenarios come together to estimate a company’s financial performance in the future. This tab will also be used to run other assumption-driven scenarios, as well as the valuation portion of the exercise that will be performed before the ultimate strategic choice.
Tab Scenarios and Sensitivities
Authorized, third-party model operators will frequently utilize the Scenarios and Sensitivities page, even if only to choose their preferred pre-programmed scenarios. As a result, you should create scenarios intuitively, safeguard the actual scenarios from outside tampering, and create sensitivities with enough variety that a few pre-programmed situations will provide a broad range of probable outcomes after sensitivity tables (example below) are created.
The Output Tab
The output tabs are the ones that model operators will utilize the most. For mid-to-complex models, I’ve noticed myself gravitating toward at least three output tabs throughout the years:
The Financial Output Tab is a condensed version of the financials provided in the model tab. They are normally presented once a year (even though the model may be quarterly). This output should consist of 50 to 150 rows and include all of the relevant line items from the computation tabs. Please include enough material so that people do not toggle between this tab and the individual Calculations tabs.
The Executive Summary Tab is very common and normally offers a combination of graphs, charts, and tables that illustrate, as simply and clearly as possible, the numerous trends, analyses, and critical summary data that executives and board members require to navigate their major choices.
The Specific Output Tab comprises specific outputs, which are frequently prescribed by the investment memo template, the investment committee presentation, or demands from executives and board members to achieve their decision points.
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Making Your Model Look Good
First and foremost, each firm/group may have its preferences or internal processes. As a result, while creating, it is critical to first check in with—and stick to—the format prescribed by your specific business. In the absence of firm-specific norms, the text below explains Wall Street’s universal language for model formatting.
One of the simplest and most basic Financial Modeling Best Practices and formatting strategies is to utilize consistent and recognizable colour schemes to signify different sorts of cells and data. As an example:
Blue = It indicates inputs or any hard-coded data, such as historical values, assumptions, and drivers.
Black = Formulas, computations, or references to the same sheet.
Green = Formulas, computations, and sheet references (note though that some models skip this step altogether and use black for these cells).
Purple = Links to additional Excel files, inputs, formulae, references, or computations (again, note that some models skip this step altogether and use black for these cells also).
Red = It indicates an error that must be corrected.
Please keep in mind that there is no built-in automated feature for color-coding your Excel files by the universal color-coding standards outlined above. Instead, you may develop your macro(s) to achieve these results, and then use shortcut combinations to automatically color-code your work.
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Links to Additional Workbooks
Finding links to other workbooks and worksheets is difficult, and you will almost certainly need to utilize VBA to get this to work properly. The main concept is to look for the sign “!” in each cell that includes a formula throughout your workbook, and then change the font color to green. In the VBA Editor, alter this to a for each loop through all instances of “!” you discover, and then change the font color for each of them.
Please keep in mind that this shortcut may not always work since certain formulas will refer to cells in other spreadsheets without explicitly referring to them. Because green cells are more common than black or blue cells, the procedure described above works quite well in most models, and you can manually style the remainder of your linkages to other spreadsheets as they appear or as you come across them.
Financial Modeling Best Practices for Auditing
Keep one question in the back of your mind while modeling: “Am I making this model easily auditable?” Since there is always a faster and better way to finish every task, develop formulas, and build links. Such hacks and procedures, no matter how great they look at the time, will ultimately be forgotten, resulting in difficult-to-trace errors. A third-party reviewer may assist you in navigating your process and making the right selections at important stages.
The following is a collection of recommended Financial Modeling Best Practices for building from an auditor’s perspective. As an example:
1. One Formula, One Row
There should only be one formula per row, which means that whatever formula is used in the first cell of any particular row should be the same formula applied equally across the whole row. Users should comprehend your model’s structure by glancing at the first cell of each row as they move vertically along your model.
While this is a simple concept in theory, it is frequently disregarded. A frequent example is when spreadsheets are divided into “historical financials” and “outer-year predictions” groups of columns.
2. There Are No Hard-coded Numbers Included in the Formulas
Hard-coded numbers incorporated in formulas should never be used since they are difficult to notice if the user is unfamiliar with the model. Instead, clearly distinguish and separate the inputs/hard codes from the formulae; better yet, collect all of the inputs/hard codes wherever applicable and aggregate them on the same tab. Following that, have your formulae pull/reference them as needed from the required cell and tab.
3. Less is Always More
It is usually preferable to avoid complex formulations. Instead, divide your formula into manageable stages. Instead of one clean row, this strategy frequently generates many more rows, resulting in a bigger spreadsheet that is much easier to follow and audit by a third party.
4. Follow Your Sign Convention Consistently
At time zero, you should decide on your sign convention/key. As an example, during the design stage of your model, ask yourself, “Will costs, expenses, deductions, depreciation, CapEx, and so on be displayed as negative or positive numbers?” It is advised to show expenses as negative numbers for two reasons: Firstly, the totals are always straight sums and secondly, the errors are more visible when just the signs.
5. Instead of Naming Your Cells, Use Excel’s Grid Logic
Wherever feasible, avoid naming your cells because it becomes difficult to discover the source input for the named cell (e.g., “Inflation”) later on. Instead, I propose that you use Excel’s grid convention in your formulae.
6. Never Use the Same Input in Several Places
Organize your inputs clearly and simply. I propose that you concentrate all inputs into a few driver tabs and reference them across the spreadsheet from their solitary places of origin.
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7. Do Not Link Files
Links to other files should be avoided. It is preferable to hard code the essential data from a separate file, which you can then manually update as needed. Cross-linking has been known to cause bigger Excel models to crash or update inconsistently, resulting in difficult-to-trace issues.
8. Do Not Conceal Sheets or Rows
Group rows/columns rather than hide them in lengthier spreadsheets.
9. Fewer, Larger Tabs Are Preferable to Several Smaller Tabs
This method is entirely based on experience. A continuous array of data over one huge, contiguous spreadsheet is easier to follow and audit than several tabs or, worse, multiple spreadsheets that are cross-linked.
10. Use “Aggregated Error Checks” to Create Checks Throughout Your Model. Located in a Single Tab
Checks are the most convenient approach to immediately assess a model’s integrity. “Checks” include everything from confirming the totals that should tie do to ensuring that a balance sheet balances. I often create a few checks at the start or bottom of each spreadsheet before consolidating them in a separate “Check Tab.” This makes it simple to locate errors in the model and track them back to their source.
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Recommended Strategies for Building Financial Modeling Best Practices
Begin with a solid, comprehensive plan for the model, as with any onerous and difficult efforts. Understand the timescale for constructing the model and its projected useful life, as well as the desired tradeoff between “reusability” and “model-granularity” as part of this process.
Next, carefully construct and arrange your model. Divide it into three components at the very least: (a) inputs/drivers, (b) computations, (the real model, which will display the anticipated financial statements), and (c) outputs.
Finally, construct the model and format it for a clean, uniform, professional finish.
How Can a Finance Professional Assist You/Your Company?
- Working as a thinking partner with you to create, arrange, construct, and produce a variety of polished models or budgets for pre-mandated specified tasks, reasons, or decisions.
- By developing a readymade, multi-tab go-to model template that can be customised by practically anybody in your business for any reason.
- By creating specified outputs and executing complicated sensitivity studies in Excel on the way to a strategic choice at the management, board, or operator level.
- By developing or generating templates for all types of Financial Modeling Best Practices, including “how-to” instructions, ranging from discounted cash flow (DCF) models and leveraged buyouts to mergers and acquisitions or cash-flow models.
- By educating individuals or groups of persons inside your firm on topics ranging from modeling fundamentals to advanced quantitative methodologies.
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Frequently Asked Questions (FAQ)
Q1. What are the Types of Financial Models?
Financial models are classified into nine types: (1) 3-Statement Operating Models; (2) Discounted Cash Flows (DCFs); (3) Merger Models (M&A); (4) Initial Public Offering (IPO) Models; (5) Leveraged Buyout (LBO) Models; (6) Sum of the parts; (7) Budgets; (8) Forecasting models; and (9) Option Pricing Models.
Q2. What are Financial Modeling Best Practices?
The process of exercising and creating spreadsheets that explain a company’s past financial data, anticipate its future performance, and analyze its risk-return profile. In other words, Financial Modeling Best Practices are the challenges of creating an abstract simulation of real-world financial conditions in advance of important choices.
Q3. What is the purpose of Financial Modeling Best Practices?
Analyze a particular corporation’s past financial performance; assess, predict, and anticipate its future financial performance; and value corporations or specific capital projects, including their risk/reward profile. They are used by business operators to make data-driven choices.
Excel is omniscient, omnipresent, and almighty when it comes to corporate finance, analysis, and data-driven decision-making, whether you love it or despise it. And, believe it or not, even for the inexperienced or uninitiated, it doesn’t have to be daunting or unpleasant. Practice, consistency, attention to detail, and, in the case of Excel, shortcuts will get you most of the way there.
Once you’ve gotten to know the program, you’ll realize it’s a strong productivity and numerical storytelling tool that you won’t be able to live without, even in your personal life. I wish you the best of luck as you go through the many levels of Excel fluency and encourage you to save this post as a practical go-to resource that you return to frequently.