Financial Modeling: Best Practices and Pitfalls to Avoid
Tags: financialmodeling, startup
Published: 2023-10-25 09:15:29

Financial model builders, like most computer programmers, tend to have strong views about the "right way" to accomplish things. The creation of financial models could be more consistent throughout the financial industry. The reason for this is that the function of a model might vary greatly. For instance, if you were tasked with developing the discounted cash flow framework to value one of five prospective acquisition targets in your preliminary pitch book, it would be counterproductive to create a too sophisticated and features-laden model. 

Given the model's intended use, spending much time on a sophisticated DCF structure is unnecessary. However, some leveraged finance models employed to approve thousands of loans of different sorts under a wide range of situations require a high level of sophistication. So, how does one go about understanding the pitfalls of financial modeling? Are the benefits of financial modeling applicable to all types of businesses? Let’s find out more from this article.


## Understanding Financial Modeling

In accounting and equity finance, the process of projecting and evaluating risk and return, as well as predicting how the future will be in financial aspects, is known as modeling or financial modeling. Indeed, bankers and investment gurus would be unable to provide exciting new investments and financial solutions to their consumers without modeling since they cannot generate profits without knowing with certainty how the acquisition is going to work out in the future. In this part, we will learn further in detail about how financial modeling works.

## What is Financial Modeling?

The purpose of [financial modeling](https://eqvista.com/financial-modeling/) is to predict the effect of a change in a company's financial situation by simulating the results on a spreadsheet. The forecast entails the preparation of the financial statements, balance sheets, cash flow declaration, and supporting schedules and is usually based on the company's past performance. 

Executives may put many different applications to a financial model. It is most often used by financial analysts to forecast the potential impact of future events or management choices on the stock price of a firm. 

## How does Financial Modeling Work?

By crunching statistics, financial modeling may depict the history, present, and predicted future of a business. Such models are developed to serve as aids in the decision-making process. They might be used by upper-level management to predict the financial outcome of an experimental endeavor.

They are used by financial analysts to explain or predict how events, both internal and external, such as changes in strategy or business model, would affect a company's stock price.

Business value estimates and peer comparisons may both benefit from the usage of financial models. In addition, they play a role in strategic planning by being used for the likes of scenario testing, cost estimation for new projects, budgeting, and resource allocation.

## Financial Modeling Example

The most useful features of financial modeling are the underlying assumptions they make. Sales growth is a popular metric to include in forecasts. Gross sales growth is measured as the percentage rise (or decrease) from one quarter to the next. A financial model requires just these two parameters to predict future sales.

The sales from the previous year (cell A) and the sales from the current year (cell B) are each entered into separate cells in the financial model. Cell C is utilized in a formula that subtracts cell A's value from cell B's value, with A being the denominator. What we have here is the formula for growth. The formula in cell C is a fixed part of the model. The contents of cells A and B may be modified by the user.

The goal of the model in this scenario is to forecast future sales in response to a given action or set of circumstances. Of course, this is but one use of financial modeling in the real world. A stock analyst's primary focus is on future expansion. It is possible to simulate every element that causes or may affect its expansion.

When deciding which stock to buy, it's helpful to do some comparisons between different firms. An investor may make a more informed choice among industry contenders when they have access to many models.

## How to Build a Financial Model?

Iteration is a key part of financial modeling. You have to work on separate parts until you can put them all together. Detailed instructions on how to get started and put it all together are provided below.

Past performance and presumptions - A company's past performance is the foundation of any financial model. The first step in creating the financial model is to compile the financial statements from the previous three years and enter them into Excel. Following this, you must reverse-engineer the historical period's assumptions by determining numbers like the rise in revenue rate, profit margins, variable expenses, fixed costs, AR days, stocking days, and AP days. From there, you may enter your forecast period's variables as hard codes.

**Create an income statement** - Assumptions for the future may then be used to compute revenue, COGS, gross profit, operating expenditures, and [EBITDA](https://www.investopedia.com/terms/e/ebitda.asp) at the top of the income statement. Costs like interest, taxes, and depreciation won't be available for calculation until later.

**Establish the balance sheet** - Now that the income statement's header is in place, the balance sheet can be generated. The first step is to determine the AR days and inventory days assumptions, both of which are dependent on revenue and COGS. Accounts payable, a function of Cost of Goods Sold and AP Days, comes next.

**Create the necessary timetables** - Creating a timetable for investments like PP&E, along with debt and interest, is necessary before finishing the statement of income and the balance sheet. The PP&E program will use the prior period, to which new expenditures on capital will be added, and old depreciation will be subtracted. The debt schedule will also draw from this period's data, adding new debt and subtracting payments as they occur. The average outstanding debt is what will be used to calculate interest.

**Carry out the DCF valuation** - After finishing the three-statement model, you may go on to determine the free cash flow and value of the company. The company's free cash flow is brought up to the present day using the cost of capital (the opportunity cost of the investment, also known as the needed rate of return) of the firm. 

**Include a sensitivity analysis and possible outcomes** - After finishing the discounted cash flow analysis and valuation portions, you should add sensitivity analysis along with scenarios to your model. The goal of this research is to quantify how modifications to key assumptions would affect the company's value (or any other measure of interest). This helps make investment decisions or formulate business strategies (e.g., should the firm seek more funding if sales volume reduces by x percent?).

**Create graphs and charts** - Good financial analysts are distinguished from outstanding ones by their ability to effectively communicate their findings to management. Charts and graphs are the most efficient means of displaying the outcomes of financial modeling. Most executives are lacking in sufficient time or patience to examine the model's inner workings, thus charts are a lot more effective means of communicating the model's results.

**Model auditing and stress testing** - The task is not finished after the model is complete. The next step is to put the model through its paces by subjecting it to a variety of stressful conditions and seeing how it responds. For further assurance of precision and Excel formula integrity, utilize the auditing tools available.

## Common pitfalls of financial modeling to avoid

Constructing a financial model can be a time-consuming and intricate procedure. Frustration is likely if the model keeps making mistakes. This is especially true when much work is spent establishing the necessary formulae and circumstances.

A competent financial analyst adheres to strict protocols and practices to prevent the common pitfalls of the profession. You should be aware of the mistakes you could make. In this part, common blunders in financial modeling will be detailed, along with solutions for avoiding them.

**No Proper Preparation**

Most people fail to consider its significance while developing a financial model. They don't give much thought to the model's feasibility. They don't have any thought as to who would use it, how, or where it will be implemented. Others fail to take into account the critical data and reports required to build the model. Overcomplicating a model is possible if certain factors are ignored. Problems may arise, such as the disclosure of unnecessary details or the omission of essential elements. To keep from making this mistake:

- Determine the economic issue this model will address
- Locate the model's intended audience and describe the model's intended application
- Find the model's inputs, procedures, and products
- Organize inputs for faster development
- Carefully plot out the framework of your model

**Insufficient Logical Foundation**

Financial models often consist of several sheets that must be meticulously organized. Users may have trouble navigating between sheets if they are organized improperly. They make it hard to keep track of which sections you presented in different sheets.

This shortcoming may be remedied by isolating the contributing components and expanding upon them over many sheets. Make it simple for readers to go from one sheet to the next. Make sure there is a smooth transition from one sheet to the next, both horizontally and vertically.

**Construction of Overly Complicated Models**

Your company will benefit from having access to additional information provided by a well-informed model. More assumptions, however, lead to less realistic conclusions. Predicting the future is a daunting task. It takes more time and could not even provide the intended outcomes if you have to make precise assumptions about dozens of various parameters. 

Keep the number of unstated assumptions to a minimum while creating a financial model. Your model may include some unstated assumptions. However, input fields and formulae will be necessary for more flexibility in explicit ones. Strive for the middle ground between the model's adaptability and its complexity.
 
**Formula Mistakes**

Formula-related errors seem to be the most common. They may be the most elusive as well. For instance, while putting together the formula, it's simple to forget a crucial piece of information. The formula may not have been copied through correctly. It's also possible that certain pieces of information are missing.

For whatever cause, incorrect formulas will lead to inaccurate financial modeling. This means you need to be cautious whenever you add or modify a formula in a working financial model. When adding columns or rows at the range's boundary or in cells with fixed references, use caution.

**Covering Up The Columns And Rows**

Another catastrophic mistake, obvious as it may seem, is to hide rows and columns. There will be rows of data and computations in the model that won't make it into the final product. It's tempting to tuck them away for a more polished look. The issue is that you run the risk of presenting false or misleading information. It may also cause inconsistencies in computations and the pasting of formulae. Do not hide rows unless necessary; instead, group them.

**Failing to Provide an Executive Summary**

Including an executive summary improves the model's readability. As a result, the reader may grasp the fundamental premises, drivers, and other considerations right away. The overview gives a quick look at the whole model. It facilitates a quick understanding of the most important facts and the reasoning behind them. The summary of your financials can help you zero in on what information is most important to highlight when presenting your numbers.

Your focus should be on simplifying the model's usage for the benefit of the user. Make it easy for readers to get the degree of detail that most interest them. A table of contents, directions, explanations, and assistance would all be useful additions. These aid the reader in applying the model.