Steps to Create a Financial Model

Financial modeling is not a perfect science. In fact, it would be fair to say that financial modeling is part art and part science. This is because the specific steps required to create a financial model cannot be chalked out. However, there is a broad framework which needs to be followed in order to create a working model.

The major steps which need to be taken in order to create a working financial model have been listed in this article below:

1. Step #1: Start With Historical Facts: If the company preparing the financial model has been in existence for some time, it would be a wise move to start with its historical financial statements. This is because an analysis of the past statements often reveals hidden trends which may shape up the future.

   However, it needs to be understood that past trends are only indicative, and the future could be very different. However, in many cases, financial models are developed for start-up companies where there are no past details available. In such cases, details of a comparable company can be used, or this step may have to be skipped.

2. Step #2: Isolate The Parameters: The purpose of a financial model is to accurately forecast the revenues and the expenses which may occur in the future. However, it is important to understand that these revenues and expenses do not function in isolation.

   These revenue and expense numbers are actually the result of an interaction between several underlying parameters. Therefore, if an attempt is made to predict the numbers without understanding the parameters involved, it is likely that the predictions will not be very accurate.

   Hence, understanding the key parameters which influence the business is of vital importance. These parameters may be specific to the industry or even to a specific organization.

   For instance, companies which use commodities as their input or output must be mindful of the effect of fluctuations in commodity prices.

   For example, an increase or decrease in steel and cement prices will have a huge impact on the real estate industry. Similarly, if a company derives a major part of its revenue from exports, then it may be vulnerable to fluctuations in currency rates.

   At the end of this stage, a financial modeler must have identified all the relevant parameters which are likely to impact their business. These parameters must be isolated and provided as an input to the user. This will provide the user with the ability to vary the parameters one at a time and validate the results.

   The individual effect of each parameter on the breakeven level and the profitability can be identified if the model has been designed well.

3. Step #3: Identify Cost Behaviours: A profit and loss statement shows a static view of the expenses involved. However, the reality is that not all expenses behave in the same manner when the volume of production increases or decreases.

   For instance, depreciation charge remains the same, regardless of the output that a machine produces. Similarly, labor charges remain more or less fixed in the short run, regardless of whether they are used for production or not. However, there are costs such as raw materials, which vary directly with the level of production. Also, there are costs such as electricity which may increase with the increase in production. This is because successive units of electricity are more expensive as compared to previous ones.

   It is important that this behavior of different costs has been fed into the financial model. This will ensure that the model gives reliable results when it is simulated to know the expected profitability at different production levels.

4. Step #4: Identify Inter-relationships Amongst Parameters: A financial modeler must ensure that their model is logical at all times. For this reason, it is important that they identify the inter-relationships between various parameters and also model them.

   For instance, a rise in price would have an inverse relationship with the quantity sold. Similarly, a rise in one expense may sometimes reduce or even eliminate other expenses. The problem is that the relationship between parameters is often complex and non-linear. Identifying and modeling them accurately is an art which needs to be learned over several years!

5. Step #5: Provide a Range for all Parameters: More measures need to be taken to ensure the logical accuracy of the model. It is for this reason that all parameters which have been identified need to be given a range. If the results of the financial model go beyond a certain range, it should throw an error.

   Companies, then need to run thousands of iterations of these tests to ensure that all possible errors have been identified and even rectified in the process. The end result would be a sturdy and dependable model which can be used for decision making.

6. Step #6: Scenario Analysis: Lastly, the financial model should be built in such a manner that it does not give only one result. The reality is that the future is highly uncertain, and decision-makers would be better off if they are provided several scenarios.

   For example, the best-case scenario when revenues are the highest and the costs are the lowest. The worst-case scenario when costs are the highest and revenues are the lowest.

The bottom line is that financial modeling is an extremely complex task. These steps provide a broad guideline to accomplish the task. However, the reality is that there are several more tasks which need to be undertaken based on the specific financial model being created.

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