What is the Financial Modeling Code?
The financial modeling code serves as an essential guide to financial analysts and companies looking to predict future financial performance based on various assumptions and historical performance. The code explains how to build financial models, providing guidance on the models’ layout, appearance, and functionality. Users can create understandable, robust, and error-free financial models by following the code and adhering to the best practices.
Companies also use financial models to assess their risk and return profile based on their financial data. Financial modeling is structured around the three main financial statements, i.e., income statement, balance sheet, and cash flow statement.
The management of most companies relies on the assumptions and outputs of financial models to make business decisions on potential investments in private or public entities, corporate transactions such as mergers and acquisitions, and pricing securities.
- Financial analysts and companies follow the financial modeling code to create understandable and error-free financial forecasts.
- A financial model should include a clear purpose and defined output so that users are aware of the possible outcomes.
- The model should consist of clear and logical sections, with a consistent flow from the inputs and calculations to the outputs.
Planning a Financial Model
Forecasting a company’s financial process using financial modeling is a complex process because each business is unique. The first step when building a financial model should be to prepare a blueprint at the onset to save on time and reduce errors. Without careful planning, there can be unexpected structural changes during the modeling process, which can be expensive in terms of time and resources.
Before building a model, the key stakeholders should review the blueprint and contribute any preferences they would like to see in the final model. The financial model’s goals should be clear so that the stakeholders are conversant with the purpose and expected output.
Users should be aware of what the model can do and what it cannot do. Knowing the possible outcomes of the model makes it possible to ascertain the potential of the financial forecast.
Key Elements of Financial Modeling Code
The following are the key components of the financial modeling code:
1. Layout and design
The layout of a financial model impacts the user’s ability to comprehend and use it correctly. The model should be designed so that there are clear and logical sections to make it easy for users to find sections that are useful when predicting future performance. Users should be able to understand the flow of logic and make adjustments where appropriate. There should be consistency in the flow of logic, starting from the input to the outputs.
The key components, i.e., inputs, calculations, and outputs, should be segregated into separate worksheets or made distinct using sections within the same worksheet. For the calculations, there should be separate calculation worksheets for each function, such as operations and tax.
If the company oversees different business units or divisions, the model should contain structured worksheets for each unit. The model should come with a simple navigation system with elements such as a diagram, collapsible panes, and a table of contents.
2. User interface and transparency
A financial model is a tool that users interact with regularly, and it should come with a simple interface that is easy to use and understand. A model is created to be used by multiple users, most of whom are not involved in creating the tool.
Therefore, the model should include a user guide that provides guidance on the proper use of the spreadsheet. The user guide should be part of the workbook and not as a separate file that may be separated from the model in the future.
The financial model should provide a unique input location for each value to guarantee the transparency of the system. Creating multiple input locations can cause users to make mistakes when updating the inputs, and therefore, adopting unique input locations can reduce such errors.
The calculations should also be structured in a way that each calculation refers to the single input location. Rows and columns should be visible and easily accessible. They can be grouped and collapsed when users need to exclude them, but they should not be hidden, or else the reader may get confused and delete them by mistake.
Ensuring consistency in a financial model can help reduce the complexity of the systems and improve user experience. There should be consistency in the components that perform similar tasks, specifically in relation to formula selections, calculations, and input/output sections. Formulas should be consistent across blocks of formulas to prevent errors where formulas are copy-pasted over an inconsistent formula block.
The formulas should be consistent across groups of products. If the model covers multiple timelines, there should be consistent placement, such that a single column in the model should only contain values that relate to a given period. It should represent the period across other relevant worksheets that share the same timeline.
A financial model relays financial information to different users. There should be clarity in how information is communicated to prevent confusion and disagreement among its users. The model should use clear and consistent formatting by employing appropriate number formats to separate different data types from each other.
Also, the model should use visible and meaningful labels for all data, calculations, and outputs so that users understand the data presented. When the model includes multiple values, the units of measurements should be clear to make it easy for users to understand the information. Each value or set of values should be labeled with the appropriate unit, such as currency, percentage rate, or factors.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)® certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful: