How to create a Financial Model and What are the Best Practices
Finance modeling is the partial definition of the company’s earnings and expenditure compilation on an MS-Excel sheet with the perspective of how the company is currently doing, how it did in the past, and how the future may look after some measures are taken. Financial models help the company management anticipate the expenses and revenues accrued from the undertaking.
Regarding finance modeling, Ian Edwards argued that external influences such as government intervention or internal changes like business restructuring may determine a firm’s stock price. Furthermore, these models can also be used to arrive at a firm’s share price or make comparisons with wild peers.
Steps to create a Financial Model
1) Understanding the Business Model:
It is important to know what fuel the company uses, how it earns money, and who its clients are. The core value propositions, the competing edges, and how the consumers perceive the enterprise.
2) Collecting Data
If any, try to request past financial records. Check industry benchmarks and marketing investigations. Try to gather as much information as possible regarding the terms of sale, pricing, and methods of selling the goods or services.
3) Input from departments
Consult with the heads of departments to solicit their opinions and expectations. Bring their budgets, expenses, and expectations for development.
4) Plan Model’s Layout
Consider what schedules to include in what is included and excluded, how to maintain the same format, and what the important results will look like.
5) Extended Operating Plan
Work out an elaborate extended operating plan covering sales forecasting, production plans, and human resources requirements. Do not forget to consider the seasonality and trends of the market in your operational plans.
6) Cost and Revenue Projections
Classify the costs into two: fixed and variable. Bear in mind inflation and a rise in prices. Make assumptions on sales volumes and the respective prices of each of the products or services. Consider how it will gain new customers and retain the existing ones.
7) Capital and Tax Expenses
Always recognize and plan for any excessive capital outlays, especially new machinery or technology enhancements. Ascertain the timing of these costs. Pertaining to the revenue and costs, undertake the corporation tax correspondences. Confirm the rates, plans, and provisions.
8) Financing Assumptions
Define clearly where the finance will be sourced and give options such as equity, loans, and grants. Include the details of interest rates, repayment period, and terms of finance.
9) Working Capital
Predict accounts receivable and payable turnover as well as the inventory turnover rate. Assess how much working capital is required.
10) Sensitivity Analysis
Perform sensitivity analysis of the key assumptions to determine the strength of the model and produce several scenarios to demonstrate differing results.
11) Construct 3 statements. Model
Prepare the income statements, developed for each of the periods in your model. Prepare also the balance sheets as well as the cash flow statements.
12) Review and Validation
Validate your assumptions against relevant stakeholders. Scan through the model for any inconsistencies or errors. Document your assumptions, where this data came from, and how you did.
13) Dashboard and Visualization
Develop charts and graphs and other visual representations that are applicable to your financial model to promote comprehensibility.
14) Sensitivity Testing
Evaluate, by changing essential input and other assumptions, the degree to which the model is sensitive to change.
Best practices for financial models begin with knowing the objective of the model and the principal drivers of its forecasts.
Best Practices
However, learn about business models, because they can be quite convoluted. Getting the hang of these can make a whole world of difference. Start with immersing yourself in sales, researching sales networks, ROI, market positioning, and the customer journey from first contact to possession.
More reliable assumptions lead to reliable sources; document them properly. Connect your ERP with FP&A solutions, all in one tool covering all of your spreadsheets; more integration is better. Inform your board about the assumptions and aims of the model before scheduling any meetings.
Work hand in hand with departments and create the heads of departments as your allies. Get relevant information from them. To put it succinctly, storytelling is the Holy Grail that enables your model to tell a plot that is coherent in its narration. When it comes to the many schedules in a model, go for the few that are ideal—not many. Advanced sensitivity, scenario planning, and sensitivity analysis should be used.
Have different sheets for the assumptions, the data inputs, and the summaries. Visuals are important because no board wants to sift through row after row and column after column.
Accuracy and consistency should be checked at the top of every page where it is required. In case your model has numerous schedules, consider the inclusion of a table of contents for easy navigation.
Ensure that there is uniformity in terms of formatting on all the schedules. Concentrate on critical variables such as how sensitive sales are to the price and quantities. Attach only the three statements and don’t incorporate formulas in those projections.
Evaluate the way your results stack up against industry benchmarks and within the company. Good financial modeling not only assists in evaluating performance today but also assists with strategizing for the future and making decisions. It’s all about embracing dynamism in a fast-changing market that is quite sad.
