Financial modeling strategies

Building out a financial model is not as hard as it seems. Let's take a step back and look at the overall process. There are six steps in building a financial model. 

Step one involves going through and gathering the data that we need to build that model. Typically, we're gonna start with our historical financial statements. So we need to gather them up and then we need to read them and make sure that they make sense. Reading them is not as bad as it often seems. So if you're not an accounting person and you're adversed to financial information, I recommend you go through and give it a try. They're really not as complicated as you might think. 

Second, our next step is to go through and change the arrangement of the financial statements. We need to make sure that we've got them arranged, income statement, balance sheet, cash flow statement, and that they make sense from a readability standpoint. So we wanna make sure that we're starting with revenue through net income, and that we've linked them together in a readable, usable fashion. So have them all in one place, rather than on separate sheets in Excel. 

Step three is to go through and compute our historical ratios based on our past financial statements. And then that's gonna give us some kind of mechanical assumption. For example, looking at accounts receivable to sales or our depreciation rate, or our cost of goods sold to revenue, et cetera. We need to go through and compute those ratios because that gives us a starting point for our assumptions. 

Step four is to develop the financial model. So we're gonna go through and develop revenue, expenses, and cap ex by working through the different value drivers in the financial model. Determine what it is that drives those factors, those business outcomes, and then make sure we're modeling them appropriately. 

Once we've got the assumptions in place, we're prepared to finish working through the income statement and then the cash flow statement, and finally the balance sheet. We need to make sure that we check that each of these items make sense against one another. For example, does the amount of cash on the balance sheet check against the amount of cash generated from the cash flow statement? We need to do that consistently so we make sure there's no errors in our model. 

And then step six is to go through and determine the outputs that we care about. So for example, valuation or perhaps sensitivity analysis might be the goal in a typical three statement model. We wanna understand where the firm is going in the future and what the value of the company might be or the expected net income might be as a result. 

Now, a couple of key best practices to be aware of. First of all, I wanna say at the outset, don't be obsessed with best practices. The reality is it's dangerous to become obsessed with these best practices and models because number one, it can become bureaucratic and a waste of time. There are almost always exceptions to best practices out there. 

Next, we wanna make sure that we're going to go through and keep our formulas the same across the financial model. And that's gonna let us expand that financial model to future years more easily. But the reality is that even for something like keeping the formulas the same there can be exceptions if we have the business change. If there's, say, a merger and acquisition or another major corporate event. The point is that we wanna make sure that our model is readable and that we have the appropriate labeling or range names for all of the cells in question. 

In fact, rather than focus on best practices, it's often useful to think about avoiding bad practices. When we think about what is a bad practice, it's really something that either A, leads to errors in our financial model, or B, makes the financial model more confusing. So for example, we wanna make sure we avoid long formulas that are difficult to read. This is probably the single worst problem in financial modeling. The second big problem that I see is when we don't keep inputs together. We wanna make sure that all of our inputs, all of our assumptions are in one place and that they're easy to use, easy to identify, and that they're logically consistent with the financial model as a whole. Now you should have a high-level understanding of what's involved in financial modeling and the pitfalls that you wanna avoid when you're building out your model.