A modeller has the skills to review the logic and integrity of a model and can check calculations from an operational and economic perspective.
Whether you are a professional or a business owner, understanding
how to review a financial model can greatly enhance your financial acumen.
So how do you review a financial model?
There are many key steps to review a financial model effectively so you can make informed financial decisions.
Why Review a Financial Model?
Before delving into the details of how to review a financial model, let's first understand why it is important. Financial models are used to project future financial performance based on historical data and assumptions. They serve as the foundation for investment decisions, budget planning, valuation, and risk analysis. A well-constructed financial model can provide valuable insights and drive strategic decision-making. However, errors or inaccuracies in a financial model can lead to costly mistakes. Therefore, reviewing a financial model is crucial to ensure its accuracy, reliability, and usefulness.
Here are the steps you need to take.
Please note that reviewing financial models encompasses
many different aspects. These steps are the basics you need to know:
Verify Data Integrity
The first step in reviewing a financial model is to verify the integrity of the data. This means ensuring that all the input data used in the model is accurate and up to date. You should cross-reference the data sources with reliable, current information. If the model includes historical financial data for a company, make sure it matches the actual financial statements of that company.
For example, if you are reviewing a financial model for a startup business, ensure that the revenue and expense figures are based on realistic market research and industry benchmarks. Check for consistency and accuracy in the data used to create the model.
Understand the Assumptions
The next critical step in reviewing a financial model is to understand and evaluate the assumptions. Financial models rely on a set of assumptions to make projections. These assumptions can include growth rates, inflation rates, interest rates, and other relevant factors. You should scrutinise these assumptions to ensure they are reasonable and justifiable.
Suppose you are reviewing a financial model for a real estate project. Examine the assumptions related to property appreciation rates and rental income growth. Are these assumptions in line with historical trends and market conditions? If not, they may need adjustment.
Check Formulas and Calculations
A financial model consists of various formulas and calculations that determine the outcome. To review a financial model effectively, you should go through these formulas and calculations to ensure their accuracy. Even a small error in a formula can lead to significant discrepancies in the results.
Let's say you are reviewing a discounted cash flow (DCF) model; check the formulas for discounting future cash flows. Ensure the formula for calculating the present value is accurate, and the discount rate is correctly applied.
Validate Model Structure
Another crucial aspect of reviewing a financial model is to validate its overall structure. This involves checking that the model is logically organised, easy to navigate, and user-friendly. A well-structured model should have clear inputs, calculations, and outputs, with proper labels and documentation.
In the case of a financial model for a manufacturing company, verify that the model structure separates fixed and variable costs, making it easy to assess cost drivers and their impact on profitability.
Test Sensitivity and Scenario Analysis
To make the model more robust, it's important to conduct sensitivity and scenario analysis. This involves varying key inputs and assumptions to see how the model reacts. By testing different scenarios, you can assess the model's sensitivity to changes in variables.
Imagine you are reviewing a financial model for an investment portfolio. Perform sensitivity analysis by adjusting expected returns and risk levels. This will help you understand how the model responds to different market conditions and risk profiles.
Verify Output and Reports
Once you have gone through the internal components of the financial model, it's time to verify the output and reports generated by the model. These outputs may include financial statements, valuation results, or investment recommendations. Ensure that the outputs are clear, accurate, and consistent with the assumptions and calculations.
If you are reviewing a financial model for a retail business, verify that the income statement, balance sheet, and cash flow statement are generated accurately, and they reconcile with each other. Any discrepancies should be investigated and resolved.
Document the Review Process
Documenting the review process is essential, as it provides a clear record of the steps you've taken to review the financial model. This documentation can be useful for future reference and for sharing the model with others, such as colleagues or stakeholders.
In a corporate setting, it's essential to maintain documentation of the financial model review process, including notes on data sources, assumptions, and any adjustments made during the review.
How to Become a Master of Financial Modelling
Reviewing a financial model is crucial in ensuring its accuracy and reliability. By following the steps outlined above, you can effectively evaluate financial models, identify errors or inconsistencies, and make informed financial decisions.
But here’s the kicker:
Enrolling in Financial Modelling Courses can provide you with the exact knowledge and expertise needed to excel in the field of financial modelling.
To enhance your skills in reviewing financial models, enrolling in Financial Modelling Courses is highly recommended. By participating in such courses, you can gain valuable knowledge and practical experience that will make you a more effective financial analyst or decision-maker.
At Redcliffe Training, we offer a range of
Financial Modelling courses designed to cater to individuals at different skill levels. Whether you are looking to build a strong foundation or are more experienced and aim to refine your skills, our courses can provide you with the expertise you need to excel in financial modelling. Join our courses and learn from industry experts who will guide you through the intricacies of financial modelling.
FAQ
What should a financial model include?
At the basic level, a financial model should cover revenue projections, expense forecasts, cash flow statements, and profit estimates. It should also encompass assumptions, growth rates, sensitivity analyses, and scenarios to assess potential outcomes. Factors like market trends, risk assessments, and key performance indicators are integral. Finally, it should offer clarity and ease of understanding to aid decision-making processes.