Financial models are an essential tool for businesses, investors, and other financial professionals to understand the performance of a company or sector. However, complex financial models can be difficult to navigate, leading to misinformed decisions. Fortunately, with modern advances in technology, it is easier than ever to simplify these models and make them more accessible. In this article, we will discuss the advantages of simplifying complex financial models and explore some of the best practices for doing so.
Financial Model Basics
In its simplest form, a financial model is a mathematical representation of how various financial variables interact with one another. Financial models are often used to predict the long-term performance of an enterprise or sector. These models can be extremely complex, making them difficult to understand and use. But simplifying a model does not necessarily mean eliminating variables or details from the equation. Instead, it means creating a financial model that is easier to understand by reducing complexity.
Factors to Consider
Before creating a financial model, it is best to define the purpose of the model. This will help you decide which factors to include and how much detail is necessary. For example, if you are creating a model to predict the financial performance of an enterprise, you may want to include details about the company's budget for research and development or its marketing budget.
Breaking Down Complexity
The most complex models are usually made up of several smaller models. For example, a model that tracks a company's financial performance for an entire year is more complex than one that tracks the same company's quarterly performance. The same is true for a model that predicts the performance of 10 different companies versus one that predicts the performance of only one. The best way to tackle a complex model is to break it down into smaller models.
Keeping it Simple
A complex model is not always the best model. Sometimes a simpler model will give the same or better results with fewer variables and fewer steps. For example, instead of using a dozen equations to predict earnings per share, you might be able to use only one equation that's easier to interpret. For many companies, the number of variables you need to run a model can be surprisingly small.
One of the most important aspects of a good financial model is how easy it is to interpret. If you can't understand what's going on in your model, then you won't be able to make good decisions based on that model. It's easy to get carried away with complex models, but if the model is too complex, you won't be able to use it effectively. You can always add complexity later. The first step in creating a good financial model is to start with a simple one.
Financial Models While you can create financial models by hand, it's not really practical. Instead, it's better to use an automated approach. You can do this using Excel or with specialized software such as Microsoft Dynamics GP. Many companies use a combination of both. Excel allows you to quickly create a financial model and then use that as the basis for a Microsoft Dynamics GP model. Excel allows you to do this because it is essentially a programming language.
Financial models are really a way of thinking about a business. They help you see how each part of the business works together and what impact each will have on revenue and expenses. Financial models show you how the business works and where your biggest opportunities are to improve. They also help you better understand your financial statements and develop a report that is easier for others to understand.