What Makes a Good Financial Model?
What Makes a Good Financial Model?
The expression “Garbage In, Garbage Out” quite literally applies to modeling and forecasting. To create a good financial model with relevant insights and output for a company, the forecast assumptions should be based on recent company historical financials or on the reliable market and industry metrics.
For example, reviewing a company’s historical revenue growth or COGS and expense items as a percentage of revenues provides a recent trend or average that can then be applied to the forecast years. If a company is operating in a large or global industry where growth assumptions and average profit margins or expenses are available, then these “market averages” can be applied to forecast assumptions. In both cases, the user is able to support and defend the forecast assumptions with actual historical company financials or credible market/industry data, then the model’s output and insights will generally be considered to be reasonable.
Below is a list of guiding principles for the structure and design of a financial model which makes it “user-friendly” (e.g., easy to use), more flexible, and adaptable to developing different case scenarios for a company (e.g., merger, acquisition, LBO) and in testing certain changes in a company’s operations or financials (e.g., cost-cutting initiatives, new market expansion, changes to debt structure).
- Group forecast assumptions together in one area of the model. This will be easier to access and will make it more efficient to review and understand model inputs
- Change the format of “negative” numbers to reflect a negative number (e.g., brackets around the number). This will make the review of both the inputs and outputs easier to digest and more efficient to spot any issues
- For simpler, smaller models, a three statement financial model in one tab (worksheet) of excel will make the building and review much easier. It will also make any links from new worksheets (e.g., valuation, merger) more efficient
- Worksheet pages should be organized consistently with similar titles and column headings, and consistent formatting, fonts, font size, and use of font color. This will make the online or printed review much more efficient to review
- Do not have too many or unnecessary assumptions and line items. This creates a “clean” and logical model to both use and review. It will also make sharing the model with another user easier
Key Learning Points
- A good financial model should be flexible. i.e. the user should be able to adjust forecast assumptions for any possible situation that a company may consider
- A good financial model relies on actual company historical information or credible industry/market information to defend or support forecast assumptions
- Good financial models have a clean, well-organized design and layout which makes them more user friendly and will make the online or print review of the output more professional looking and much easier to digest
- A good financial model has consistent titles, column headings, font, and color schemes
Developing reasonable and sound assumptions, reviewing company historical results and key metrics and ratios, and researching for industry or market data and projections are ways to enhance the credibility of your financial model and avoid a “Garbage In, Garbage Out” scenario. Equal time and care should be considered when developing the layout and structure of your model as well as the “cosmetic” features of your model (e.g. font, font size, color scheme, column headings). A good financial model is one that is easy and efficient to use, review and understand, and one that creates insights and outputs that are relevant to the company.
Download the accompanying Excel exercise sheets to practice financial modeling and for a full explanation of the correct answer.