Financial Modelling Principles

By Shaun Scoon, Associate Director of ScaleUp Group

A well-built financial model will demonstrate to prospective funds that you truly understand the key drivers of your business. In addition, it will prove that you are a business leader who understands the possibility of there being many eventualities, potentially impacting your business and that your plans are robust enough to cope with them.

What is Financial Modelling?
Financial modelling is the use of software to create decision support tools for businesses. In other words, a financial model is a mathematical tool, typically a spreadsheet used to calculate the financial impact of a business decision under a range of scenarios and to communicate the potential outcomes of that decision to interested stakeholders. The latter point is important: the clarity and user-friendliness of the presentation are second only to the accuracy and integrity of the business logic.

Note also: a model is just a model. No model can hope to replicate reality precisely. Model users need to recognise that it is only a simulation of a deal or business, and further, will only be as good as the assumptions and data that underpin it.

In practice, models can be one of the most important components of a fund raise. They represent the meeting point where information on the commercial, operational, financial, legal, fiscal and economic factors relating to the fund raise, and theory interrelationships, are synthesised and summarised to explain the consequences of a transaction.

The financial modelling process

The process of developing a financial model is similar to any other development process: plan, execute, check and use. In a financial modelling context, the process can be described as follows:

  1. Model specification – The starting point should be the development of a model specification, a document that defines the problem and sets out the proposed approach.
  2. Development – once the desired shape of the model has been determined and designed in outline, the next task is to turn the specification into a live model. This phase is the coding of the specification into a dynamic spreadsheet model
    • Collate and organise the source data/information
    • Set up the workbook and worksheet template layouts
    • Design and implement the model output formats
    • Develop, programme and test the individual calculations, remaining mindful of the eventual outputs; and
    • Document the model (e.g. user guide)
  3. Testing– Check to ensure that working or calculations do what they are expected to do when assumptions and/or data change. It is often best to test as you go because it tends to concentrate on bite sized elements of the model’s logic and reduces the risk of testing results becoming opaque due to ‘noise’ from other factors. 
  4. Review – After the model has been constructed, it should be subject to a comprehensive independent review. Comprehensive because you can’t risk missing an error by testing on a sample basis; independent because it is extremely difficult for a modeller to self-review 100% effectively. This is why we advocate a third party/advisor review. 

Best practise and principals

Modularity and separation of inputs

The first principle is to keep inputs separate from calculations and calculations separate from outputs, ideally on separate worksheets. The developer should ensure that each input is only input once, in a dedicated input cell, and therefore easily updated should it need to be changed.

Consistency and periodicity

The second principle to observe is that of consistency; namely, consistency of timeline and worksheet layout across worksheets (i.e. any given column on any given sheet should represent the same time period in the modelled timeline), a consistent period duration along the timeline, consistent formulae blocks in a row or column (from left to right or top to bottom), consistency of approach to like calculations, to formatting and to descriptions and an internally consistent data set.

Transparency and simplicity

The third principle is to make the model transparent and simple to follow. The design should facilitate this by using clear descriptive labels for calculations, using bite-size formulae, and using formatting styles to assist the audience in understanding the purpose and function of individual cells. The hallmark of transparency should be that the user can work out the function of a cell or group of cells using only a printout of the model and can replicate individual cell results using little more than a pencil, ruler and calculator.

Linearity and flow of calculations

The fourth principle relates to the flow of logic and data through the model. Generally, a model should be laid out to be read like a book, i.e. from left to right and top to bottom. This principle should be applied rigorously within worksheets, recognising that occasionally a calculation will have to reference subsequent working blocks.

Integrity and robustness

The fifth principle is that all financial models should include a full set of integrated financial statements with appropriate error and balance checks. Depending on presentational requirements, pro forma financial statements will often suffice – the key point being that they are fully integrated and independently calculated.

Building these checks and flags in from the start provides reassurance that the model has been built correctly throughout the development process and should therefore be easier to debug. It also minimises the time required to find and resolve modelling errors, because they are identified earlier, and it is more likely that a given error condition is the result of a simple error in isolation, as opposed to becoming compounded with other errors, which becomes more difficult to identify and unpick.

Protection and validation

The final principle is error prevention. Excel’s security features can mitigate the risk of accidental amendment of code and its validation features can help to restrict the values that users can input into the input cells. This reduced the risk of a user breaking the model by using invalid or unplanned inputs, or by making amendments to existing formulae.

Conclusion

It is important that the principals are understood and that any deliberate breach of them is done in a controlled manner and with a full appreciation of the risks. Building a financial model that adheres to these principles will set you apart from other startups and immediately enhance your credibility when facing off with funds. Reiterating an earlier point; the financial model is a powerful tool that gives prospective funds a valuable insight into your understanding of an industry, business operations and more importantly thought process. Not adhering to these principles (which will require significant time and resources) could undermine all your hard work and have a detrimental effect on any fund raise aspirations.

At ScaleUp Group, we adopt a methodical approach to building financial models whilst working in close collaboration with entrepreneurs. Our modelling process is where science and art intersect to yield optimal fund raise outcomes.

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