People have a misconception that Financial Modelling is a very difficult task and it takes a lot of effort to build one. Financial Modelling is often regarded as one of the most difficult exercises in the industry and some people find it nearly impossible to build one financial model.
Here, in this article, I will give you some useful tips which will make your model building exercise much easier. These are some of the easy steps to be adopted while working on a model that will make the exercise more fun. These tips will make any model look professional and will majorly avoid any chances of hassle being faced by the analysts and the investors/ evaluators.
1. Understanding of the Industry and Competitors
Some start working on the model directly post the company’s evaluation without even reading about the Industry. However, it is equally important to get a sense of the industry and doing a competitive company’s analysis in order to make the projections.
One should keep in mind that the projections should not be majorly off from the Industry standards and competitors unless there’s a specific reason to justify the same deviation.
It is always considered a good exercise to gather knowledge of other companies’ financials and ratios before projecting the target. This makes the model more reliable and in line with the Industry.
2. Colour Coding
Make different colour codes for the following to make it easily understandable by the model evaluator:
- Audited Numbers
These colour codes can be in the form of cell background colour, font colour, font size, font type etc. There are two major benefits for colour coding:
- It makes a model look professional
- One can easily distinguish the numbers in the abovementioned heads
3. Make a separate tab for Assumptions
It is required to make a separate tab of assumptions in your model and you’re required to keep it separate from all the numbers. The assumption is the most critical part of the model and it serves as a foundation for the projections taken. Hence, investors want to specifically take a look at the assumptions taken.
4. Discussion with the Management
It is extremely important to get the assumptions validated by the management once. As management is running the business and they understand about the company better than anyone. Analysts can write the numbers on excel but it is in management’s hands to make those numbers real.
Analysts should properly discuss these numbers with management and take their observations into consideration. And, the model should be discussed with the majority of people in the management.
5. Make notes for any business point/ observation
A model can be built on various numbers and various scenarios, it is important to list all the observations and critical points in notes for an investor to understand the assumptions taken. Notes justify the answer for taking x assumption instead of y.
For Example; if a company has decided to source their raw materials from a different vendor which is offering them materials at a lower price. It will reduce the raw materials costing taken in Statement of Profit & Loss by some percentages. Mentioning the same reason in notes will give investor/ evaluator an understanding as to why the reduction in raw material prices is built in the model.
6. Break complicated formulas into pieces
Incorporating complicated formulas in a model makes it difficult for others to understand. To make a model more understandable, you are required to split all the complicated formulas or all the complicated steps into various formulas and steps respectively.
Breaking of steps will be slightly longer than the previous complicated method but it will be easy to operate while you will be working on the model along with making it simpler for others.
It there is any complicated formula used in the model, then it is important to provide its simple breakup in notes with proper examples.
7. Make “Index”, “Summary” and “Charts & Graphs” Tab
The model consists of several tabs and it takes hours to go through each and every model item in detail. Hence, analysts are advised to make a summary and charts tab separately for all the important numbers including Revenue, Gross Profit, EBITDA etc.
It gives a summary of the important values forecasted in the model and one does not have to go through the whole model to understand the business in brief. They can simply take a look at these two tabs in detail.
You can also insert hyperlinks on the index sheet for one to directly reach to the required tab by just clicking on the hyperlink. Also, hide some of the extra working files in your model for clean-up.
8. Audit the Model
Once you complete the model, get it auditing by a couple of people to remove all the unexpected errors. There are two ways of auditing:
- Do audit yourself- By checking each and every formula inserted and the assumptions are taken.
- Share with others for audit- It is important to get the model audited by at least 2 people because every other individual will come up with their own points and they will not miss something which you might have missed.