Finally, to create a control panel, i.e. a one-page summary where we can change the most important assumptions and see immediately how this impacts on the KPIs of interest.
The importance of this step is to ensure that the proposed model is easy to read, easy to understand, easy to change, and simply easy to use. The way to make a model useful and readable is to keep it simple. The complexity of the transaction which has to be modelled and the complexity of the model itself are 2 different things.
1.3.3 Step 3: Designing and Building the Model
Designing and building the financial model is the next phase of the process. The specification phase (Step 2) should lay out the structure of the model in detail. In this step we first identify the outputs of the model. It is good practice to present the output of the model on a separate sheet. This output sheet is a combination of model inputs and formulae and should read directly from the workings sheet of the model. There may be more than one output sheet in case the resolution of step 1 requires the handling of uncertainty and creating sensitivity analyses. Moreover, the control panel described in the specification part of the modelling process, if any, is part of the output of the model. Next we build the assumptions sheet that forms the inputs to our model. If our model needs past data to build on, i.e. historic financial statements, we collect them and adjust them to the right level of detail. Depending on the problem we have to solve we will not need all of the income statement, balance sheet, and cash flow statement accounts, and thus some will need to be grouped together. Finally we build the workings or calculation sheets and fill their cells with formulae. Thus, the sheets where the calculations are taking place should always be separate from both the input and the output sheets. Also no hard-coded values should be typed directly into the calculations of the workings sheet. In case the purpose of the model is to forecast future financial statements, all the relevant key drivers of the historic financial statements are calculated and forecast into the future. The forecast key drivers will make the building blocks of the future financial statements as we will see in Chapter 3 where we will build a financial model from scratch in order for the reader to grasp all the aforementioned abstract rules.
The following indicate best practices that will help you build models that are robust, easy to use, easy to understand, and painless to update. Best practices are of greatest concern when documents are used by more than one person:
○ Use a modular design to divide your model into sections such as: Documentation, Data, Assumptions/Inputs, Workings, and Outputs, as we have already mentioned above. The first sheet of the model should serve as a user guide, step-by-step documentation as to how the model works. It may seem time-consuming, but it greatly increases the productivity of the whole team, and frees up time when, at a later stage, as you try to remember how you built the model, you will need to revise it.
○ Always avoid hard-coding numbers into formulae and try to keep your formulae as short as possible. Always split complex formulae into multiple, simple steps.
○ Use formatting for description rather than decoration. For example use different colour text for assumptions compared with formulae and output results. Use consistency in colours (e.g. blue for inputs) to highlight cells where data must be entered. When using more colours do not forget to add a legend explaining what each colour means. Always keep in mind the KISS principle: Keep It Simple Stupid.
○ Present the data as clearly and in as uncluttered a form as possible. Always separate inputs into at least 3 columns, one with the particular inputs, the second describing the Units of Measure (UOM) of each input, and the last one with the values of each input.
○ If you distribute your model to others, do protect it to prevent inadvertent changes. By default, anyone can change anything on any spreadsheet. To prevent unauthorized changes you should either protect your worksheets or your workbook as a whole. As a workbook owner you should always keep one copy of your original model in a directory that only you can change.
○ Designate ownership and track who is changing what. If you decide not to prevent changes in your model then try at least to monitor them. To do so you can simply make use of the Track Changes tool in Excel 2010 and 2013. Microsoft's Track Changes function allows revisions to be made to a document and keeps a complete record of all changes made. Track Changes can be invaluable if you have created a business document and you distribute it to others to work with it.
○ Design your worksheets to read from left to right and from top to bottom, like a European book. This is a common recommendation in the literature. Perhaps it is a remnant of paper-based documents, but it seems that following such a design does make spreadsheets easier to navigate and understand.
○ Finally when incorporating charts in your model, always label the axes and use titles.
Although this is not a book on how to build good spreadsheets, the interested reader could visit the site of The European Spreadsheet Risks Interest Group – EuSpRIG10 where they can find plenty of information and research papers about spreadsheet best practices. Perhaps one of the most important papers on this site is that of IBM – Spreadsheet Modelling Best Practice. This is a 100-page guide on how to develop high quality spreadsheets. This guide is of interest to anyone who relies on decisions from spreadsheet models. The techniques described include areas such as ensuring that the objectives of the model are clear, defining the calculations, good design practice, testing and understanding, and presenting the results from spreadsheet models.
1.3.4 Step 4: Checking the Model's Output
The model is not ready until we ensure that it produces the results it was designed to. Errors in the data or formulae could be costly, even devastating. The received wisdom is that about 5 % of all formulae in spreadsheet models contain errors, and this rate is consistent across spreadsheets. Errors may occur at the functionality level, the logic level, the design level, etc. A simple way to check our model is to introduce checks directly in the forms. Some of these checks will be very generic and will therefore be included early. For example in case of a balance sheet the obvious check is the sum of assets vs the sum of equity and liabilities. In case of a cash flow statement the cash and cash equivalents at the beginning of a period should be equal to the cash and cash equivalents at the end of the previous period. Moreover the cash and cash equivalents at the end of a period should be the same as the cash account of the balance sheet of that period. Other checks will be more model-specific, and the need for them will not be obvious at the beginning – therefore, new checks will be included throughout the model building phase.
As a minimum, we can test our model subsequent to the building phase by playing with the inputs and see if this produces reasonable results (reasonableness tests). For example, if a formula is supposed to add a set of values then we can test it by providing known data, and checking that the answer is the expected one. Moreover we can change each of the input parameters and see if the output results change accordingly.
There is free textbook on Wikibooks (Financial Modelling in Microsoft Excel/Testing)11 which provides a detailed checklist of the best practices on how to error-check a spreadsheet. From checking its functionality, i.e. whether the model does what it is supposed to do, to checking the business logic in the model. From identifying the risk factors, i.e. what could go wrong, and how serious that could be, to checking the inputs of the model and its calculations, i.e. examining all formula cells, where they read from, and where they feed their result to.
Of course there are error-checking tools that can make our life easier. Excel 2003 and later versions have a built-in error-checking tool. For example in Excel 2003 under the Tools menu, just select Error Checking. If the Excel Error Checking tool detects a possible error, it pops up a dialog box. This box gives several choices, which range from ignoring the warning to taking action. The more updated the version of Excel the better the error-checking tools that have been incorporated. However,
