Models designed from zero vs. model templates
The origin of the publication that we summarize here was the negative reaction towards the publication of a template to develop a financial model. Henikoff believes that templates should never be used. As a result of this reaction, both authors met and ended up convinced that entrepreneurs should take their time to design their models from scratch instead of using templates.
And this resulted in an interesting article for all those who have been playing with the idea of making a financial model for their companies and doing it by pulling templates. It presents a brief guide to designing a financial model and the most important factors to take into account.
Reasons to build the financial model from scratch
In their article, the authors provide arguments to defend the position that you have to design your financial models from scratch.
Templates need to be revised
The first reason is that a template has always been designed with a case in mind, which obviously will not be ours. There are numerous financial models designed by analysts who have taken a specific company as a model for their templates. And this itself can already be a problem since the model is “inspired” by another foreign company.
There is no shortage of templates circulating the internet, and in fact, many entrepreneurs pull them for their models. Either due to lack of time, lack of practice or not knowing how to design your model. Although it is helpful to learn from other people’s models, in the authors’ opinion, third-party experiences should not be used for a real case.
And why is that? Because the headache will occur at the moment in which the differences and specific features of a company come to light, which will require changes in the workforce. This will be more difficult to change on a prebuilt model than on a custom-made model, and initial ease will take its toll later with headaches in later phases.
The headache will occur when the differences and specific features of a company come to light, which will require changes in the workforce.
It may lead to not dominate the investor´s jirga
As the financial model is the basic tool used to communicate projections to investors, it is essential to know the investor jargon. The pitches or interviews have a limited duration, and if you manage to get to an interview, it is fatal not to understand the precise vocabulary. This financial jargon is often related to the use of models in Excel. Using a template can lead to missing the exact terms and their meaning in the model.
Elements that make up a good financial model
Creating your model forces the modeler to always be clear about all the concepts that it handles in the model. They can even be as basic concepts as standard financial statements, balance sheets, income statements, cash flows, and other terms. Understanding and knowing how to use these values is crucial for knowing how to explain or present a model, whose credibility depends both on the inclusion of historical data and on projections within the same spreadsheet. All key concepts should be reflected in their corresponding sections.
A crucial issue for the credibility of a model is to correctly reflect real liquidity. You can have opinions about the benefits, but liquidity is a fact. The financial model will always contain a subjective assessment of profitability, which will be offset by the actual data from the bank accounts.
Why the Investors are interested in knowing the financial model
A sound financial model is, in the authors’ opinion, a decisive step in communicating with investors, as it proves logical reasoning and a defined, understandable and reproducible business plan, predictable risks and realistic benefits.
Good models are built from the bottom up, starting from the most basic components and building the financial-business framework from these. The basic components are expressed in assumptions and with real data or, in the absence of them, with the most realistic possible assumptions. The quality of these projections and assumptions will determine the quality and credibility of the model.
The quality of the assumptions will differentiate a financial model from the milkmaid’s tale.
Anyone who wants to work as an analyst in an incubator, get the attention of investors for their projects, or talk to the bank from you to you, should learn to understand and make financial models so as not to get their fingers caught with templates that they do not control 100%.