Financial modelling is an important skill for any finance professional, but it can also be an intimidating one. Fortunately, the use of Excel can make the process much simpler and more efficient. By using our top tips for building financial models in Excel, you can create better models in far less time than ever before.
In this post, we’ll cover some key principles in financial modelling, provide a comprehensive list of tips for working efficiently in Excel, and share advice for developing a successful financial model. By incorporating these best practices, you’ll be able to streamline your process, save time, and create more effective models.
- Understand key principles in financial modelling
- Implement tips and strategies for working in Excel
- Develop a successful financial model
- Streamline the process and save time
- Create more effective financial models
Understanding the Purpose
When constructing financial models using Excel, it's important to first understand the purpose of the model and the audience who will be using it. A financial model should be tailored to meet specific needs, and answering the following questions can help you develop a model with necessary details and appropriate assumptions.
What is the Goal of the Model?
What is the purpose of creating the model? Is the goal to project financial statements over multiple years, or to analyze a potential acquisition? Knowing the specific purpose of your model will enable you to create a model that is detailed enough to achieve its intended goals.
Who Will Use the Model?
Who will be using the model? Will it be seen by financial professionals within your own company, or will it be presented to potential investors or lenders? Depending on the audience, the level of detail, accuracy and assumptions you incorporate in your model will vary.
Consider Model Inputs and Outputs
It's important to consider the inputs and outputs of your model. What information are you using to build the model and what information will come out of it? Inputs could be historical financials, market conditions, macroeconomic factors and other variables. Outputs could be projected financials, forecasts and sensitivity analyses. Armed with this information, you'll be able to design models that capture the necessary inputs and produce accurate outputs.
- What is the goal of the model?
- Who will use the model?
- What inputs are necessary to build the model?
- What will the model output?
Data Collection and Organization
Financial modeling requires data collection, fact management and thorough organization. The following are three tips to help beginners build their Excel financial models correctly.
Verify All Data Points and Legacy Information
The first step is verifying data points and making sure the inputs are reliable. This is called ‘source verification’ and should be at the highest standard. In order to achieve this, it’s extremely important to double check every variable and make sure all the information makes sense. Old data points, also known as legacy information, should be scrubbed through as well.
Establish a Single Source of Truth
Establishing a single source of truth is the next step in terms of data collection. This is where all data points, including legacy information, are consolidated and stored in one single location. This way, everyone on the team is able to access and view the same information. It helps in creating a consistent and accurate narrative to the financial model.
Structure and Organize the Data to Maximize Efficiency
The final step of data collection is organizing the data into a structured format. This maximizes efficiency by allowing users to quickly scan and identify the required information. In order to structure the data, organize it into sections and highlight any key points. You can also use in-cell formulas and conditional formatting to make the information easier to parse.
- Verify all data points and legacy information
- Establish a single source of truth
- Structure and organize the data to maximize efficiency
4. Model Format
Building a financial model in Excel requires the use of an efficient and consistent format to ensure accuracy and speed. Determining the right approach can be overwhelming. Here are some tips to help you create a professional and organized model.
A. Use consistent formatting practices
One of the most important rules of building financial models is to ensure consistency. Once you establish the cell formatting, worksheet naming conventions and object naming conventions, stick to them. This will make the model easier to read, simplify the development process and ultimately, make it more useful.
B. Apply interactive formatting rules
When working with financial models, you want to be able to quickly scan the data and recognize patterns. Configuring Excel’s conditional formatting capabilities can be a huge help in this regard. For example, you can use this feature to color-code the cells based on the value they contain, making it easy to quickly identify outliers in the data set.
C. Set up object naming conventions
Building a financial model often involves the use of multiple objects, be it range names, pivot tables, charts or graphs, formula or macros. To make your model easier to navigate and debug, make sure to develop a naming convention for all the objects used in your model. This allows all members of the team, including yourself, to easily understand what the object is used for and to quickly identify the corresponding object.
5. Model Documentation
Investment analysis through financial modeling requires intense attention and accuracy to detail. To ensure your models are correctly and appropriately used, it is critical to provide detailed documentation. There are three primary considerations when documenting a financial model.
A. Generate comments to document assumptions
A financial model contains assumptions about how the team expects the market and a company to operate, investments to be made, and returns to be incorporated. Generating comments to document these assumptions, such as an expected rate of return from investments and the estimated cost of debt, can assist in validating and revising these assumptions and providing more visibility into the decisions that were made when constructing the model.
B. Maintain a detailed history of changes
Creating a thorough history of changes allows entities to comprehend the evolution of the financial model and identify sections that require modification. This detailed history should include the date of the change, a description of the change, and any documentation of the underlying assumptions that were modified.
C. Define appropriate version control
Version control allows entities to keep track of edits to the model and help protect against errors. It is regularly suggested that entities utilize a sequential versioning system for their financial models to ensure there is a clear understanding of how and why changes were made.
- Label the version number using “vn.n”, where n is a positive integer and the version number follows an incremental order
- Use meaningful descriptions and tags to clearly explain the entire scope of the changes
- Set up a system to manage the versions of the model efficiently
Model Performance Testing
When creating financial models in Excel, it is important to assess their performance, accuracy, and viability. To do so, users should consider running tests and conducting comparative analyses to ensure that the insights and outputs of the model can be reliable and useful going forward.
Test model accuracy and functionality
To test the accuracy and functionality of a financial model, users should first check the consistency of their summation, comparison, and lookup formulas. Inconsistencies can lead to errors in the accuracy of the model. Consistency in functions such as pivot tables, named ranges, and formatting should also be evaluated when testing the accuracy of the model.
Run sensitivity analyses
For further accuracy and reliability measures, financial models can also be tested with sensitivity analyses. Sensitivity analyses see how the data and outputs within a financial model can change when different variable inputs and assumptions are taken into consideration. This is a good way to get a better understanding of the effects of changes in variables on the overall accuracy of the model.
Debug errors and alarms
The final step of assessing the performance of a financial model is to debug any errors or alarms. If errors or alarms are not taken care of, it can lead to distrust in outputs from the model. To debug any errors, users should check for things like typos and conflicts between formulas, as well as inconsistencies between data sources.
Financial models enable businesses to accurately assess the success of projects, investments, and capital expenditures. When constructed in an efficient manner, these models can enable businesses to make informed decisions that minimize risk and maximize profit. This blog post has provided you with a comprehensive guide to developing financial models in Excel.
By following the tips outlined in this guide, you can utilize Excel to create robust models capable of accurately forecasting and evaluating financial outcomes over long-term horizons. Key points to keep in mind are to understand the purpose of the model, build the model in an organized manner, test the model as you go and use best practices for formula calculation and logic.
It is essential for businesses to invest in their financial processes and build models that are accurate, efficient, and reliable. Properly built financial models can help provide clear and tangible insight into how different decisions will impact the overall financial picture of the business. We hope this guide has provided you with the fundamental knowledge you need to confidently build financial models in Excel.