Financial Modeling – Best Practices

Financial Modeling is a tool that can be used to forecast a picture of a security or a financial instrument or a company’s future financial performance based on the historical performance of the entity. Financial Modeling includes preparing of detailed company specific models which are then used for the purpose of decision making and performing financial analysis.

The principles of best practice outlined here are for the purpose of reducing errors, making a model easier to read, audit, update and use for its intended purpose. This list is by no means exhaustive, but outlines the most important principles in Financial Modelling. By following these key principles, your model is easier to navigate and check, and much more likely to be robust, accurate, reliable and error-free.

  • Spreadsheet Design
    Using modular spreadsheet blocks will make changing each sheet easier without affecting others. Proper protection should be given to the sheets and workbooks from unauthorized usage and labeling sheets, columns and rows with their applicable headings so that files will become easy to follow.
  • Hard-codes = landmines
    It’s a fundamental rule of basic modeling but it must be said. Never put a hardcode and a formula in the same cell. All hard-codes or “inputs” should pull out of formulas and consolidated in an inputs / assumptions section. Never repeat an input and always change their color to blue so you can find them easily.
  • Keep it simple
    Don’t fall victim to Excel black magic (long and complex formulas in your financial models). Not only are long formulas prone to error, they become incredibly difficult to use for business analysis once a model grows to a certain point. Reduce spreadsheet risk by breaking down complexity in the model.
  • Only enter data onceNever enter the same value twice; enter it in once as a source and always reference to that one cell. Never use a value within a formula eg. =IF(G$6>=$E7,136800,0) should have a link, not 136800 typed in. However, do not link source data to a cell which itself has been linked to the original source. Always go directly to the source data.
  • Incorporate powerful analysis
    The most transparent financial models are the ones that come fully equipped to answer crucial questions. A reliable framework will let you run sensitivities on your key model drivers, and this vital when reducing stress in real world business analysis.

In general these best practice guidelines outlined above are really just common sense. Whilst some of them may seem tedious and overly prescriptive to the beginner, most of these points are for the purpose of reducing error and bringing increased robustness and clarity to the model. These practices are probably second nature to the experienced financial modeller who will most likely already follow these guidelines by instinct.

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