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Best Practices and Steps of Financial Modeling
Financial modeling is a tool that can be used to forecast a picture of a security or a financial instrument of a company’s future financial performance based on the historical performance of the entity. Financial Modeling includes the preparing of detailed company-specific models which are then used for the purpose of decision making and performing financial analysis.
Financial modeling is the constructing of a financial representation of the aspects of the firm or given security consisting of the mathematical models of financial health of a given company. This model can be made on a simple notebook paper or in Excel, which is then analysed for the impact of different assumptions or changes in value of various variables.
Financial modeling is a mirror that shows whether an organization is in need of additional funds (debt or equity) and how a business will react to different financial situations or market conditions. It helps to understand if the company would be a good investment for better returns i.e. comparative analysis and risk level, such as identifying if the company has had a recent change in direction, loss of customers, lack of demands and overabundance of supplies, etc.
Identifying of Strategic and Business Plans through finding strengths and weaknesses.
It is a technique to value and analyze Firms, IPOs and FPOs.
A good financial model should:
- Be relatively simple
- Focus on key cash flow drivers
- Clearly convey assumptions and conclusions
- Evaluate Risks
Financial Modeling forms a core of various other finance areas like equity research, investment banking, credit research, etc. If you are searching for a Financial Modeling Online Course/Training then you may consider one of our Financial Modeling courses here.
Applications of Financial Modeling
The purpose of Financial Modeling is to build a Financial Model which can enable a person to take better financial decision. The decision could be affected by future cash flow projections, debt structure for the company etc. All these factors may affect the viability for a project or investment in a company.
The Applications of Financial Modeling mainly includes the followings:
One application of Financial Modeling may be Business Valuation which is deciding the fair value for a business. Financial Modeling will help participants to reach to a price they are willing to pay or accept for the selling business. The second application of financial modeling is an organization’s decision making and scenario preparation. Financial Modeling is used by organizations for future planning their long term goals according to different situations that may arise.
To decide the Cost of Capital – if a company is going to invest in a new project then Financial Modeling for it will give analysis for debt/equity structure and expectation in return by investors, thus setting benchmarks for project to meet.
Capital Budgeting – Financial Modeling helps companies determine allotting resources for major expenditure or investment etc.
Purpose – increasing the value for the firm.
Project Finance: Financial Statement Analysis
Basic Financial Analysis tools include:
- Common size financial statements
- Analysis of Various Ratios
- Trend or Pattern analysis
- Industrial comparatives
Best Practices in Financial Modeling
In Financial Modeling it is desired that the working should be error less and should be easier to read and understand for audit purposes. By following these key principles, model will be easier to navigate and check, and reliable.
For most obvious results we need to follow the Firms standard format:
- Maintaining appropriate number of sheets
- Using page breaks wherever required
- Writing Executive Summary on top if desirable
- Maintain versions of documents if future up gradations are expected
The following points should be kept in mind:
1) Spreadsheet Design
- Using modular spreadsheet blocks will make changing each sheet easier without affecting others.
- Proper protection should be given to the sheets and workbooks from unauthorized usage.
- Labeling sheets, columns and rows with their applicable headings so that files will become easy to follow.
2) Better Document Your Assumptions
- Assumptions documentation helps with validation & avoids misinterpretation.
- Listing assumptions will be helpful for easier and quicker understanding.
- Adding source data as well as calculations will provide a good map.
3) Use Linking and Not Hard-coding
- Linking wherever required will be a good practice such that when the inputs change, the outputs will be changed automatically.
- It will save lots of hassles at final stage or at working stage
4) Facilitate Data Entry at One Place Only
- Avoid retyping of data, entering it once as a source and referencing it will make good sense.
- It’s always better to link cell value rather than writing numeric value for calculations.
5) Good Practice is Using Consistent Formulas
- Using formulas and functions will be accurate and will save time.
- Do not copy formula from one sheet to another as it will create links in files.
- Avoid unnecessary blank columns and rows as this can be tedious at the time of making tables or other charts.
- Creating Templates will be beneficial.
6) Formatting Charts
- Be precise with chart axes scale
- Creating a VBA Style Guide containing rules and details about coding standards is good
7) Format and Label Clearly
- It’s very important to format cells appropriately i.e. we should follow standard practices eg. we should use symbols for currency , percentages values etc., which will make model easier for reading.
- In Financial Modeling clear labeling is very important to improve readability.
- Try using different background colors for distinguishing input areas and calculation parts.