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Despite the introduction of new financial technology, Excel has continued to be an integral part of financial modeling. For this reason, finance, operations and business professionals should be comfortable working with data and building effective models using Excel spreadsheets. The output of a financial model depends on the quality of assumptions used in the model and how well the model has been built.
While there is no "right way" to build financial models, certain best practices for modeling and creating well-structured and effective spreadsheets in Excel can go a long way in providing the kind of actionable insights you need to make critical business decisions. In this blog, we'll be answering the question - "what are the best practices for financial modeling in Excel?"
Like any other business procedure, the financial modeling process should be standardized within various teams or across business units. This helps you better understand the data flow across a model and how spreadsheets are interconnected.
Standardized formatting may include using distinguishable color codes for inputs, outputs, hard-coded values, formulas, sheet tabs, etc. Usually, different sheets should be used for inputs, calculations and outputs. The data flow across various spreadsheets should be consistent and easy to follow.
You may be tempted to make financial modeling calculations and formulas complex, however, remember that less is more. It is usually more effective to work with simpler models that can be adapted for different driver inputs.
Creating a standard data flow in spreadsheets can help create simple, clear and effective financial models. Simplicity reduces the work hours that an end-user may spend trying to understand the data and key outputs used in decision making. Consequently, senior management can make timely business decisions.
When you document the process of data flow in a model, this provides a guide for third parties to understand the model and derive insights from the model results independently. Creating a guide sheet in a model explains how data flows, how assumptions and inputs connect to create outputs and insights.
Documenting a financial model's flow and procedures also helps with succession planning. Business changes happen and you or your colleagues may move between teams and departments. That's why a clear procedure document helps with easy transitioning.
When color coding or other formatting types are used in Excel spreadsheets, provide a formatting guide that describes the purpose in clear and simple terms.
Describe key performance indicators that have been used to measure performance.
Having separate assumptions and input sheets allows you to quickly identify the drivers that impact the total output of a financial model.
The quality of a financial model's output depends largely on the assumptions used. Ensure that assumptions are reasonable and can be justified. Provide a rationale for assumptions that have been used in the model as well as sources of input data.
It is also good practice to describe key performance indicators that have been used to measure performance in a financial model. This way, non-subject matter experts can understand the financial results and insights better.
A good financial model can capture possible scenarios that could occur and how they can impact key business metrics.
The business environment experiences uncertainties and ambiguities in various forms. A good financial model can capture possible scenarios that could occur and how they can impact key business metrics. Scenario analysis recognizes different scenarios based on multiple varying input drivers while a sensitivity analysis usually focuses on the impact of a sole input driver. For example, the financial results of the banking industry are highly dependent on interest rates.
A sensitivity analysis can show how a bank's performance can be impacted by a single rate change policy.
Incorporating effective scenario analysis into your model can help drive a proactive approach to business planning.
Version tracking is a key practice that helps monitor the changes in model assumptions, inputs and corresponding outcomes. When decision metrics are modified in the model, tracking the model allows you to compare the results of different versions.
A good version tracker will identify the changes that are made, who made the changes, why the changes were made and the impact of the changes on key business targets. Vena's native Excel platform provides a simplified layout for integrating databases and managing versioning in financial models.
Financial models with flexible and adaptable designs allow for quick model adjustment and modifications.
Agile practices also cut across financial modeling. A proactive approach to business planning may include changing an assumption in a model to analyze the underlying impact. Financial models with flexible and adaptable designs allow for quick model adjustment and modifications. This comes in handy when key decisions need to be made urgently.
Data visualization is a tool that provides a pictorial representation of business performance. Data visualization can be used for granular operational metrics such as daily production units, job hours for specific projects, customers served, etc. It can also provide a summarized picture of higher-level financial performance such as annual revenue forecasts, gross margin, net income, amongst other key performance indicators.
Integrating Excel spreadsheets with databases can drive real-time analysis and promote business intelligence. Effective financial models can pull in data from different sources to create key data visualization for actionable business insights.
Summarize the key output insights in an assigned sheet to show the key performance indicators in comparison to business targets and goals. Data visualization can also be useful in a summary page.
At a glance, the summary page provides the key outputs that senior management uses to make informed decisions.
Even the best financial modelers or Excel experts can miss out on some errors or improper data flow.
Even the best financial modelers or Excel experts can miss out on some errors or improper data flow. Using checks across a financial model can help you identify and eradicate model errors.
Model checks are a way to ensure that a financial model that will be used for key business decisions is complete and accurate. Use tools, such as condition formatting, to quickly spot duplicates, misplaced data or material errors. Data validation can also be a good tool to prevent the inaccurate entry of data that does not belong to a specific list.
Excel best practices in financial modeling lead to higher data quality and consequently drive accuracy in output results.
This promotes more effective decision making for businesses across all industries. What better way to start incorporating Excel modeling best practices than to learn from industry experts and professionals through the Vena Plan To Grow community.
Companies with rolling forecasts reported 43% more revenue growth over a 24-month period according to the Aberdeen Group.
As Senior Director of Content and Communications, Jonathan Paul leads content strategy and execution at Vena, overseeing the development of owned media and content experiences that help finance professionals fuel business health, as well as their personal and professional growth. When he's not dreaming up new ways to offer audiences value through content creation, Jonathan loves to lose himself in an immersive video game with a solid narrative, lose golf balls pretending to be good at golf and lose time dreaming about time travel.
