Improving model quality

Once you've finished building your three-statement financial model, there are a few things you can check to make sure you have all the right parts and pieces in place. To begin with, you want to make sure that you've translated all of your value drivers: price, cost of new capacity, and the cost structure into your financial statement projections appropriately. In particular, you need to go through and minimize the operating data so that you have just one measure of capacity and one measure of sales. Remember, a financial model is a simplification of reality. If you put in too much detail, you're gonna find an overwhelming amount of information, and that'll make it more difficult to make decisions effectively. You also need to go through and evaluate the historical relationship between your value drivers and your financial variables. So don't just use a generic variable. Instead, think about what it is that's really driving those particular sets of relationships. It's fine to say that we're just gonna use the average of salary and benefits for the last few years. But that's gonna be less accurate than if we can go through and say what is it that drives the change in salary and benefits? Was there a change in minimum wage, for example? Or perhaps we had a major union contract come up for renegotiation at that particular point in time. We need to think about what are the real drivers behind the scenes, and that'll let us make more accurate assumptions in the future. Remember, there's no generic formula for establishing value drivers. Instead, those value drivers need to be based on what's going on in the real world. From there you should determine how the financial structure, that is, your outstanding debt, affects financial performance. 

When you're finished, you want to go through and arrange the items in a way that's easy to read. So you should have an opening balance sheet. And then from there you should have several key items. You want to make sure that your financial model reports total non-cash current assets, total non-debt current liabilities, total fixed debt to be repaid. And all of this needs to be translated into a debt schedule. The aggregate of all of your debt issues should tie back to your balance sheet. You also want to make sure that your history for your revenues, expenses, and depreciation make sense based on what your projections are for the future. If historically a firm has grown sales, at say, a 3% rate, and you're projecting that they're suddenly gonna begin growing at a 10% rate, that's probably not gonna be a very accurate financial statement when you get all done. Look at what the drivers are in these key items. What is it that truly drives revenue behind the scenes? Think about the size of the pie, the size of the overall market, and the amount of market share you have. What is it that drives those particular top-line items? You also want to use depreciation, historically, to figure out what your depreciation rate should be going forward. Depreciation, while it's a non-cash expense, is still very important to take into account over a long-term financial model, why? Well, because presumably you're gonna have to reinvest in cap X in the future as that asset becomes more and more worn out. Now, at this point, you have all the information you need to go through and check your own three-statement financial model for completeness.