Creating a Revenue Model
February 12, 2025
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The creation of a financial model is like a project which has to be undertaken by the company. This means that just like any other project, testing the functioning of the financial model should ideally be included in the project. However, in most cases, testing the financial model is generally the last phase of the project. As a result, the timelines are already stressed. This means that rigorous testing is often overlooked. In many cases, this has severe consequences down the road. In this article, we will have a closer look at why and how the financial model must be tested.
Calculations which are thrown up by the financial model, form the basis of many decisions made. As a result, it is essential for a financial modeler to ensure that the results are reliable. However, it is important to understand that a financial model has several thousand calculations which run at the same time. Hence, it is impossible to guarantee that the results given out by the model will be accurate and precise. However, if the model is tested rigorously at different stages of its lifecycle, most of the mistakes will be weeded out.
If testing is not done rigorously, it is likely that errors will be discovered at later stages. Errors detected by the decision-makers significantly undermine the confidence in the model. Hence, in this case, prevention is definitely better than cure.
When a financial model is being created, the words testing and auditing will be used almost simultaneously. This often creates confusion in the minds of financial modelers who begin to assume that both testing and auditing are the same processes. However, the reality is different.
Testing refers to the correctness and accuracy of each calculation which has been built into the model. On the other hand, auditing just checks whether the model created by the team matches the business requirements. For instance, if the users asked for a ten year DCF model, the auditors would check whether the model was created for ten years and incorporates all the other assumptions which were specified by the business. Testing, on the other hand, would include checking each and every calculation which led to the numbers which were used in the cash flow model.
Testing requires the user to have a thought process different from the people who built the model. As a result, financial models should be tested by someone who has not been a part of the build team. However, in order to thoroughly test the model, the user needs to be a subject matter expert. In an ideal scenario, the user should have worked with other financial models and hence should be well aware of the intended functionality of the model.
Financial models are never built all at once. Instead, they are built in several stages. During the first stage, a basic functioning financial model is provided to the users. In later iterations, more and more functionalities are added to the model. Hence, testing needs to be done more rigorously as the stages progress. Finally, the model must not be provided to the business until all the known issues have been fixed. This approach allows us to break down the humungous task of testing the model into smaller, more manageable tasks.
There are various functionalities which need to be tested while testing a financial model. Some of them have been listed below:
Hence, it would be fair to say that the testing phase of financial modeling is almost as important as the build phase. Neglecting this phase may save some time and effort in the short run. However, it is likely to cause a lot of pain in the long run.
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