Financial models – what are their real value?
Financial models can be used for a range of different purposes and they can vary significantly in complexity.
Some people use financial models to perform relatively straight forward calculations to forecast or estimate something of a financial nature. This may include working out the repayment profile of a loan or seeing what happens if the interest rate changes.
Financial models can also be used for more complex scenarios such as:
- Operating models with multiple years of projections – for example assessing what the performance of a business be over the next five years, and what happens under certain assumptions or if some drivers change.
- Investment or acquisition assessments – determining whether or not to purchase or sell a business unit.
- Valuation and discounted cash flow models – how much is a business is worth.
- Bank funding – how much can be borrowed and how much can be repaid.
- Management reporting – automating the month end reporting process by using a financial model to draw together figures from a variety of sources, or presenting the data automatically in an easy to use format.
The options are endless due to the enormous flexibility financial modelling offers but how can you utilise one in your own operations to best benefit from its implementation?
We have seen an increasing requirement for banks to review robust 3-way financial forecasts (projections which include a profit or loss, balance sheet and cash flow statement) to support applications for finance. This trend has been consistent for new to bank clients or existing clients looking to extent existing facilities. In these circumstances – the value they offer is tangible as expansion, growth and in some instances survival of businesses are dependent on finance outcomes.
But what of those businesses that are not at a level yet to require funding? This is where business owners or managements’ commitment to tracking and driving performance may determine the requirement to create and implement a model for management purposes. In a world where what gets measured often gets done, the incorporation of a budget setting strategy to set goals against what performance can be measured can be an important management tool which all businesses should consider regardless of size.
Financial modelling generally tends to be performed using Excel, however recently there has been an increasing trend for models to be prepared using financial modelling software. These software packages allow the user to input a series of assumptions which then generate a profit or loss, balance sheet and cash flow. Users of these packages should be aware of the limitations of these packages, as they have a limited amount of flexibility and may not properly fit the situation or scenario which the financial model is being used to assess (after all it’s better to make the model fit the business, rather than the business fit the model). Furthermore, if the model doesn’t quite fit the business, it may result in materially different figures being generated and thus the wrong decision being made.
Often financial models are prepared using a standard model or a template as a base. It is quite often easy to identify when a financial model has been prepared in this way, as there is redundant functionality and quite often errors which haven’t been updated or corrected due to the adjusted purpose and updated use of the
model. Again, the risk of using these models is the potential for them to present incorrect figures resulting in sub optimal decision assessment. When considering the preparation of a financial model based upon a precedent or existing model you should consider the increased risk against the potential saving of time.
How PKF can assist
At PKF we have a team within our corporate finance division which specialise in the preparation of financial models. Each model is built from scratch and tailored to meet the client’s needs.
We spend time getting to know exactly what the client wants the model to do, what inputs they would like, how they would like each input to be able to be adjusted, what the purpose of the model is as well as what outputs are required. As part of this process we lead the client though the steps to identify in detail, the answers to these questions, whilst also offering suggestions based on our experience of developing and reviewing many models in the past.
We then build the model with clear, straight forward and easy to understand input sheets, so users can make adjustments as and when they wish. This results in output sheets or a “dashboard” which is created with the user in mind, stripping down the information to just the key pieces required, whilst also preparing full profit or loss statements, balance sheets and cash flows. The calculation sheets will also be clearly visible, for users to delve into if they wish, but we would recommend they are left unadjusted otherwise it may result in errors in the model. We intentionally prepare models without the use of macros, as we have noticed users tend to prefer a more simplified and transparent approach. We also give users full access to the model’s workings, should they wish to perform their own checks or make their own adjustments.
The result of the above process ensures a robust model which is easy to use, fully integrated and most importantly, it’s designed specifically for the client’s purpose and requirements.
If you would like any assistance or wish to discuss preparing a financial model for your purposes, contact one of your local Corporate Finance representatives.