Ten Financial Modeling Commandments
So you shall keep my commandments, and do them, to give eternal life to your financial models...
A financial model is one of the essential project documents that is used by all stakeholders involved in the life of any project or deal. A financial model is mainly built in Excel. Like any other project document, the financial model should be transparent and readable. Unlike a Word document, it can be made flexible. This allows you to make changes as you review the document. In essence, a good financial model is an informative document. However, it can also be a tool for better decision making.
In life, I follow these three simple rules: "Good thoughts, good words, and good deeds." For my financial models, I follow these ten rules.
1. Thou Shalt Keep it Simple
It is horrible to receive a comment from a user and even worse from an auditor saying that your model is complex and heavy. However, keep in mind that simplicity is a relative term and must be considered in connection with the level of knowledge of the recipient. For example, a standard financial model might be labeled as complex by someone who has little knowledge of Excel and financial modelling. On the other hand, the same model reviewed by a spreadsheet engineer might be labeled as stupid.
2. Thou Shalt Separate Inputs From Calculations And Results
This is more like a Feng Shui exercise than financial modelling. For transparency and ease of access to model assumptions, dedicate a separate worksheet or a separate place on a single model worksheet for your assumptions. Also, categories your assumptions by type.
3. Thou Shalt Not Hard-Code Inputs Within Formulas
This is like an environment issue in financial models. It’s the same dilemma as why some people continue to throw their trash on the ground? Not that the input that you are hard-coding is trash but with hard-coding inside the formula, you are treating that piece of information as trash and burying it without a headstone or nameplate!
4. Thou Shalt Use Color Codes
Use a consistent color scheme to mark different types of cells and data.
Again, keep it simple. You don't want to overdo it with too much colors or crazy, over-the-top formatting.
5. Thou Shalt Avoid Long Formulas
Use the Feng Shui rule of thumb of financial models: “Do not write a formula longer than your thumb."
6. Thou Shalt Build In Error Checks
Everything might works perfectly fine in your base case but once you change any inputs, something might go wrong and you should be notified. Let me tell you a secret, I consider my models as my babies and the built-in checks as the baby monitor. So, once something is wrong in one part of my model, one of the checks will tell me that the baby needs attention. Check out my post and the Excel spreadsheet on this topic “Checkmate errors with Checks” in Financial Modelling Handbook.
7. Thou Shalt Include Sensitivity And Scenario Analysis
You need to do further modelling so that your model can start talking alternative future scenarios. Your model should be smart and should not suffice to a single worldview.
8. Thou Shalt Insert Summary Charts And Tables
The typical user should just validate and make changes to the inputs that you have clearly defined in your spreadsheet and then go to a summary sheet to see the main results. In this sheet, you can unleash your creativity and come up with dynamic and beautiful charts and tables.
9. Thou Shalt Avoid Circular References
They should have named this phenomenon “vicious cycle”. That’s what it does to a financial model.
10. Thou Shalt Not Be Selfish
Neglecting usability or user friendliness in a financial model is a costly mistake. A financial model should be easy to read and manipulate for users.
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