Improving Financial Models Through Financial Modeling Consulting
When providing financial modeling consulting and assistance services to help improve clients’ financial models, recurring inefficiencies can be encountered. These inefficiencies are found in budgetary balance sheet, income statement, and cash flow projection models, as well as capital investment decision making projections. Below is a review of three common mistakes which result in spreadsheets operating inefficiently.
Static
The first inefficiency is that the model is static. This is the most common issue encountered. Static models are spreadsheets that utilize hard-keyed calculations with no isolated assumptions or scenarios. Static models are difficult to update, lack transparency, and offer little as a planning and analysis tool. When analyzing a capital investment decision, it is helpful to see baseline, worst-case, and best-case scenarios based on favorable or unfavorable developments in 1-3 variables. By doing this, the company will have a clearer roadmap for the decision, as well as a greater understanding of downside risk and upside opportunities. This is critical for capital investment planning because it allows a hedging strategy to be implemented. In order to increase the effectiveness of a model, identify the key drivers for the calculation being made, list them at the top of the model or on an assumptions page, and then link the calculations to the listed assumptions.
Objective Measures
The second inefficiency seen is a lack of objective measures for comparison. Models that lack objective measures of comparison show raw scenarios compared to one another without any method of discerning which scenario is optimal. For this purpose, two calculations are typically utilized: Net Present Value (NPV) and Internal Rate of Return (IRR). NPV and IRR are commonly used in capital planning to measure the return of an investment. While NPV measures the excess or deficient return using a project specific discount rate, the IRR calculation simply measures the actual return of the projected set of cash flows. Sometimes one or both calculations are made alongside a calculation to determine how long it will take for the initial investment to be earned back. If used properly, both calculations can make a capital investment decision more informed.
Complexity
The third inefficiency encountered when helping clients streamline their models is unnecessary complexity. Financial models are inherently forward-looking and with that comes uncertainty. When a model is built with endless line items and dozens of tabs, this can foster a false sense of precision and accuracy. The multitude of assumptions can distract from the few key drivers that actually drive the calculation. For each line item being projected, it is important to ask if it has a material effect on the outcome of the model or if it can be combined with another line item driven by similar factors. The result of consolidating the assumptions can be a model more focused on factors impacting the calculation that is easier to navigate and interpret.
Ultimately, the goal of any financial model is to be accurate, dynamic, and easy-to-use. Outlined above are three common areas that can help elevate a model’s efficiency and usefulness, but our Business Valuation team has extensive experience modeling budgetary projections, capital investment scenarios, valuation-related projections, and merger and acquisition scenario analysis. Should you have any questions about financial modeling, whether an investment will add value to a company, or business valuation questions in general, please don’t hesitate to contact T. Eric Blocher CPA, ASA, CVA.
About the Author
Clay Dimpsey joined McKonly & Asbury in 2023 and is currently a Senior Financial Analyst with the firm. He is a member of the firm’s Business Valuation Segment, serving a variety of industries.
