Testing the Financial Model
The creation of a financial model is like a project which has to be undertaken by the company. This means that just like any other project, testing the functioning of the financial model should ideally be included in the project. However, in most cases, testing the financial model is generally the last phase of the project. As a result, the timelines are already stressed. This means that rigorous testing is often overlooked. In many cases, this has severe consequences down the road. In this article, we will have a closer look at why and how the financial model must be tested.
Why Should a Financial Model be Tested?
Calculations which are thrown up by the financial model, form the basis of many decisions made. As a result, it is essential for a financial modeler to ensure that the results are reliable. However, it is important to understand that a financial model has several thousand calculations which run at the same time. Hence, it is impossible to guarantee that the results given out by the model will be accurate and precise. However, if the model is tested rigorously at different stages of its lifecycle, most of the mistakes will be weeded out.
If testing is not done rigorously, it is likely that errors will be discovered at later stages. Errors detected by the decision-makers significantly undermine the confidence in the model. Hence, in this case, prevention is definitely better than cure.
Testing the Model Vs. Auditing the Model
When a financial model is being created, the words testing and auditing will be used almost simultaneously. This often creates confusion in the minds of financial modelers who begin to assume that both testing and auditing are the same processes. However, the reality is different.
Testing refers to the correctness and accuracy of each calculation which has been built into the model. On the other hand, auditing just checks whether the model created by the team matches the business requirements. For instance, if the users asked for a ten year DCF model, the auditors would check whether the model was created for ten years and incorporates all the other assumptions which were specified by the business. Testing, on the other hand, would include checking each and every calculation which led to the numbers which were used in the cash flow model.
Who Should Test the Model?
Testing requires the user to have a thought process different from the people who built the model. As a result, financial models should be tested by someone who has not been a part of the build team. However, in order to thoroughly test the model, the user needs to be a subject matter expert. In an ideal scenario, the user should have worked with other financial models and hence should be well aware of the intended functionality of the model.
When Should the Model be Tested?
Financial models are never built all at once. Instead, they are built in several stages. During the first stage, a basic functioning financial model is provided to the users. In later iterations, more and more functionalities are added to the model. Hence, testing needs to be done more rigorously as the stages progress. Finally, the model must not be provided to the business until all the known issues have been fixed. This approach allows us to break down the humungous task of testing the model into smaller, more manageable tasks.
Common Types of Tests
There are various functionalities which need to be tested while testing a financial model. Some of them have been listed below:
- Input Testing: Every financial model begins with inputs from the end-user. It is therefore, essential to make sure that the model does not take faulty inputs. An intelligent model has validations built-in which alert the user if unusual values are filled in. Hence, testing the model for assumptions would means purposely entering wrong values as inputs and checking whether the system alerts the user. Wrong values generally include exceptionally large or small values. They also include negative values or even zero. A well-designed model will not allow the values to be entered. A poorly designed model will take in these faulty inputs and give out faulty outputs. The user will then have to manually verify each one of their inputs to zero down the root cause of the problem.
- Numerical Testing: The numerical testing included checking each and every calculation which is performed by the model. The financial system already has some internal checks and balances. For instance, if the model includes a balance sheet, then it is supposed to balance automatically.
- Testing can also be done by comparing the two models. This usually happens when a newer model replaces an older version. In such cases, the results given by the newer model are compared with, the older model in order to find out the flaws.
- Technical Testing: Lastly, financial models need to be checked for system compatibility too. Financial models can be extremely heavy spreadsheets or applications. As a result, they may require a certain amount of computing power to operate. If this power is not provided, the entire system may crash. Technical testing is, therefore, necessary to ensure that the financial model will work as intended taking into consideration the technical specifications of the users computers.
Hence, it would be fair to say that the testing phase of financial modeling is almost as important as the build phase. Neglecting this phase may save some time and effort in the short run. However, it is likely to cause a lot of pain in the long run.
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The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
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- 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