Challenges faced in building a financial model

A financial model is a tool that is built to forecast a business\’s financial performance in the future. Mainly, the forecast is based on the company’s historical performance, assumptions, and growth factors for the future. Using the historical data and assumptions a balance sheet, income statement, and cash flow statement is prepared that show historical trends and future projections. A more advanced model could be a discounted cash flow analysis (DCF model), mergers and acquisitions (M&A), sensitivity analysis, and leveraged-buyout (LBO).

The result of a financial model is used for decision-making purposes and performing financial analysis. Some of the main uses of a financial model are to make decisions about;

  • Raising finance (debt/equity)
  • New investments
  • Expansions
  • Mergers and Acquisitions
  • Restructuring
  • Selling a business
  • Budgeting and forecasting
  • Valuing a business
  • Analysis of business performance

But there is a number of challenges that are faced in building a financial model. Some of the common problems are enlisted below;

  • A lot of time is needed to properly understand the scope of the work for which a financial model is being built. Because the purpose of the financial model is the essential step so that accurate results could be generated for decision-making purposes.
  • Collecting and aligning the assumptions that are to be used in the financial model. Realistic assumptions are necessary to make, so that future projections are close to realistic figures and hence are difficult to make.
  • Building the model in a flexible way to cater to the evolving assumptions is not easy to make. This requires extensive use of skills in financial modeling that come with years of practice.
  • Designing interactive and informative dashboards for users of the model to understand what is happening is important. This is hard to define that what sort of information needs to be displayed on the dashboard but this varies from client to client and industry to industry.
  • Sometimes there are issues with the software that is being used to build a financial model. Like, there are circular references when there shouldn’t be any.
  • At times clients are not clear on the needs as to what output they are expecting from a financial model. Resultantly, due to lack of understanding the desire results are not obtained.
  • A common misconception in the mind of users is that the financial model will accurately predict future numbers. whereas, the financial model is based on historical trends which might change with unexpected changes in economic factors.
  • Communication gaps between the client and financial modeler are sometimes a key issue that makes all the hard work can go to waste.

The application of FAST Standards can help the financial modelers to prevent some of the issues in financial modeling. As FAST Standard sets rules on the structure and detailed design of spreadsheet-based models. This standard set of rules provides both a clear route to good model design for the individual modeler and a common style platform on which modelers and reviewers can rely when passing models amongst themselves.

Nearly all modeling design decisions are objectively good or bad; a minority of modeling alternatives are simply one modeler’s preferred approach over another. Hence the FAST Standard is fundamentally organized around a set of rules – dos and don’ts.

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