By Anurag K

How to start financial modelling?

A financial model is a tool to put theories/predictions to test, a financial simulation to measure suitability of a transaction or a reporting tool to get insights into business performance.

Fred is an enthusiastic new member of the modelling community, coming straight from the B School, with good knowledge of excel functions. He just got his first project along with a colleague to build a model from scratch.
Did a course on financial modelling, where he practiced few case studies and is confident enough to take up the new challenge. Problem with the case studies is that it restricts the scope of the problem statement, clearly defined in a couple of pages and assumptions do not change. However, he's yet to realize model this is not always or rarely the case in live projects, and so modelling is not as easy as it seems.

Over the years by putting his blood and sweat Fred will realize the following.

Conceptual Design
Model building should always start with Conceptual design. It's imperative to communicate this to the modeller (Fred), before he adds the first brick to the model.

Model Structure
Best model rely on strong structural base of the model design. A conceptual design is required so a create a right model structure which guarantees to solve the objective of the model.
Modelling structure can include deciding the number of excel workbooks/sheets to keep. Whether each entity should have separate tabs or Revenue/cost calculation should be separated by tabs. Whether or which inputs should be have scenario flexing capabilities or should the input sheet be made calculation heavy in case of lot of manual adjustments.

A Good structure will enhance
- Faster rebuild / quick turnarounds of any further requests.
- Clear, transparent and quick to find / navigate the model.

A Bad model structure can have
- Potential hidden errors.
- Create hindrance in applying sensitivities & creating scenarios
- Consume a lot of time in restructuring and incorporating any further changes and lot of client's money.
- Sleepless nights for the modeller and hole in client's pocket.
- Prevent last minute changes, inflexibility during investor presentations.

The Right Question
Ask the right question if you're to find the right answers. Client will only explain what he/she thinks is necessary, not always appropriate/detailed for model building purposes. Some of the questions that will help Fred kick start modelling are as follows.
  • Timeline
    a) Duration of forecast
    b) Number of actual periods
    c) Project Phases involved
    d) Timeline flexing capabilities
  • Entities, segments, regions to be built.
  • Type and Sub types of Revenue/cost items till the minutest classification.
  • Functionalities required. Static vs relative inputs, sensitivities, escalations, scenarios.
  • Application of Recoverable tax charges like VAT/GST.
  • Key Inputs drivers / Key Outputs - This also helps in designing excellent dashboards.
  • All Financing instruments and inter-company arrangements, like cash pooling.
  • Output lines to be built

The Process
The model should start with
- Knowing client objective
- Understanding user needs
- Proper planning/designing model structure
- Specifying inputs required before jumping into calculations.

Once Fred fully realizes/understands this, it will take 2-3 years of his life. Do you think are there any more additions to the list? Please share in the comment section below.
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