Financial Modelling Heuristics
A heuristic is a technological term for what is known as a thumb rule in common parlance. In the previous article, we discussed the guidelines which need to be followed from a conceptual point of view. However, in this article, we will discuss heuristics more from a technical standpoint. The common points which need to be taken care of and the common mistakes which need to be avoided have been discussed in detail.
Never Use Constant Values
One of the biggest mistake made by financial modeling amateurs is that they often forget to separate the inputs from the calculations. For, instance, many times companies begin their cash flow calculations from their net profit after tax number.
For simplicity sake, a financial modeler may assume that the net profit percentage is 25%. However, it is important that this 25% is not directly entered into the formula in the form of a constant value. Instead, a variable called net profit after taxes should be created. The value 25% should then be entered into that variable. This variable should then be present in the input sheet.
Avoiding the use of constant values is essential to ensure that downstream calculations are not affected. For instance, tomorrow if the company wants to change the assumption and enter a 30% net profit after tax, it would mean chaos if the input was not separated from the calculation. The financial modeler will have to find out each and every point in the model where this 25% number was entered and then change it to 30%.
On the other hand, if a variable was used instead of a constant, the value just needs to be changed at one place i.e., the input screen. All variables in the calculation automatically link to the input screen. Hence, if the value is changed once on the input screen, all the values get updated automatically.
Using constant values can be disastrous from a long term point of view. Constant values make the model static. Variables help to keep the model dynamic as they allow their underlying assumptions to be changed.
Managing Circular References
A circular reference is when the value of a variable is dependent upon itself. In most cases, this is a mistake being made by the financial modeler. However, there are some calculations which legitimately require circular references. For instance, the interest expense which will be borne by a company depends upon the outstanding loan balance that the company has. However, the outstanding loan balance itself may depend upon the interest expense in a given year! In places like this, circular calculations are not conceptually incorrect. The financial modeler needs to use his/her skill to ensure that circular references are managed correctly.
A model is said to be flexible when it can be used by many different users to manage many different situations. Building financial models is an expensive proposition. As a result, companies cannot afford to build a new model every time. Hence, they need models to be flexible. It is, therefore, important for the modeler to ensure that the inputs and outputs of the model can be changed to suit different decision-making needs. Otherwise, building a financial model is just an elaborate, roundabout way of creating a decision model which will only be used one time!
Financial models are built by people who are well versed with both technical as well as finance functions. However, these models are almost exclusively used by finance personnel. Hence, they need to be built to be intuitive to finance personnel.
For instance, it is important that the model has drill-down functionality. This is because costs and revenues at the company level are nothing but an aggregation of the costs and revenues at the plant level or the store level. Therefore, if a decision-maker wants to have a closer look at the costs at a lower level, they should be able to do so. Hence, it would be a good idea to build the model in such a way that if a user clicks on a cost or revenue, they are taken to a lower level. Then, the system should allow them to keep on going at successively lower levels until they reach the absolute granular level.
This will allow companies to understand the distribution of their costs and revenue amongst various business units such as stores and departments. This information is required for better decision making. This is the reason why a financial model must provide it.
Lastly, the financial model must be visually appealing and presentable. Nobody likes information to be cluttered when they want to make decisions. A good financial model provides clear and demarcated information about the inputs which the user has put into the model and the underlying assumptions which are built into the model.
The conclusion is that there are many thumb rules which need to be taken into account while creating a financial model. The above points are only a representative list and by no means an exhaustive list.
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- What is Financial Modelling?
- Objectives of Financial Modelling
- Steps to Create a Financial Model
- Financial Modelling Heuristics
- Financial Modelling: Advantages and Limitations
- Why is Financial Modelling so Complex?
- The Future of Financial Modelling
- Creating a Revenue Model
- What is Cost Modelling?
- Important Decisions Influenced by Cost Modeling
- Financial Modeling: Important Metrics
- Scenario Analysis: A Primer
- Risk Management in Financial Modeling
- Modeling Discounted Cash Flows
- Debt Schedule in Financial Modelling
- Managing Assumptions During Financial Modelling
- Financial Modeling for Banks
- Financial Modelling for Insurance Companies
- The Merger Modeling
- Merger Modelling: The Accretion/Dilution Analysis
- Financial Modelling For Leveraged Buyouts (LBOs)
- Circular References in Financial Modelling
- Financial Modelling in Real Estate
- Why is Excel Not the Best Tool for Financial Modelling?
- Testing the Financial Model
- The Last Step: Handing Over the Financial Model
- How to Incorporate Ethical and Social Elements in Financial Modelling