How do you put together a financial model?

The quick answer is anyway you want - there are no rules but there is best practice, and following that will make the process more efficient and increase the credibility and shareability of the results. A forecast (or budget or other projection) in its simplest format is plotting values against time periods (generally weeks or months). However if you want more than a one-off exercise or for the forecast to have some level of credibility (either to you or another party) you will need a financial model.

A financial model is a theoretical representation of a financial decision-making process or project. It is a mathematical model designed to represent financial performance.

There are a number of elements that make up a good model:

Variables

To give credibility to the model each line of the model should be supported by calculations and showing the assumptions and methodology used e.g. $x per unit sold or per week/month. This also allows for scalability and can be backed up by evidence e.g. invoices or sales projections.

Sensitivity

Variables or input fields should allow changes to be easily made (to values or methodology) so as to instantly flow through the model and show the effect on the final result. This is sensitivity or what-if analysis.

Rolling periods

The model should allow for future use to add on additional, or roll forward to later periods. This should be able to be done in a relatively straightforward manner without having to rewrite the model.  This keeps it dynamic and the process continual and consistent.

Format

The outputs of the financial model (whether Profit & Loss, Cashflow or other Statement) should be relatively easy for another user to read and understand and be in a familiar format such as the regular management accounts. In addition the assumptions and inputs must also be straightforward to read and update. The backend, or calculations, of the model should also be logically laid out and be consistent to allow for possible future changes or updates.

Integration

Ideally the model should produce both a Profit & Loss (P&L) and Cashflow statement to give a more complete and thorough picture of the business or project. A Balance Sheet (BS) should also be included to act as a check as well as provide information. The opening BS plus P&L and Cashflow movements will give a closing or current Balance Sheet.

Not all of these elements are essential and some may be omitted depending on desired outcomes, audience and time or other resource constraints.

There are templates, programs and other tools available (many free of charge) for business owners or managers to utilise. An Excel spreadsheet is the most widely used tool for reasons including flexibility, ease of use, cost and portability or sharing.

 However the process will usually be far more efficient if it can be delegated to a qualified staff member, or outsourced to a professional, to manage the completeness and integrity and allow you to stay focussed on the business inputs and outputs.