An effective and efficient model is one that can help a company see and reach their future performance goals in various situations. This means that in order for a financial model to function successfully, the quantitative values that are documented need to be realistic and appropriate.
The model should reflect key business assumptions directly, without being over-built or cluttered with unneeded details. This will ensure the model remains truthful and represents reality and that it is reasonable, with previous data/ performance numbers, defensible assumptions, and projected performance.
The assumptions and conclusions must be very clearly conveyed within the model.
A good financial model will also be flexible. This is portrayed in both the design and technique, as it must allow the model to be flexible in the immediate term and adaptable in the longer term.
The model must have the ability to change with dynamic schedules. This grants model users the ability to plug various numbers into cash flow projections, depreciation schedules, debt service, inventory levels, the rate of inflation, etc., in order to run scenarios and make modifications over an extended period of time by different analysts. A good financial model should be able to be adjusted and manipulated in any field. The key to flexibility is simplicity.
3. Easy to follow and understand
Lastly, a model must be easy-to-follow. In order to really get the most out of a model for both the analysts and the business owners, the entire model needs to be easy to read and follow. In other words, the model needs to make the complex look simple.
Principles of Financial Modeling
A good financial model should obviously be free of errors and should be very easy to read and understand. With that, these principles will cause the model to be easier to navigate, check, and rely on.
1. Consistency and formatting
Consistency in a model layout and organization is essential to be sure the reader understands its logic and that it is able to be successfully passed from author to author. This consistency can consist of appropriate columns, the number of sheets, page breaks, numbers and formulas, as well as proper formatting.
Efficiency in a model will allow both the person putting the model together and the analyst to make the best use of their time. This means really paying attention to the formulas and numbers that are going onto the sheet. It also includes how these numbers are organized and portrayed with the end goal in mind.
As mentioned above, the model needs to make the complex look simple. The model needs to be easy to follow for not only the one producing the model but also those dissecting it and using it to forecast future financial numbers.
So, what makes a good financial model? Hopefully, this guide has shed some light on what makes a good model and how you can go about building one yourself. CFI is the official provider of the Financial Modeling & Valuation Analyst (FMVA)® designation and on a mission to help you advance your career. To learn more, check out these additional free CFI resources: