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How To Use Excel For Financial Modeling

by EASA Software in All Blog Posts, Spreadsheets

How To Use Excel For Financial Modeling

In order for a business to prosper in the face of its market’s changing needs, it has to constantly adapt. And to successfully do this, it needs to be able to forecast what could happen in the future. This involves the company analyzing patterns in past and current data, and taking into account future variables such as inflation, new product launches and political events to predict future performance. For example, a business may want to forecast the resulting increase in raw materials or inventory costs due to an expected rise in sales.

Without forecasting, companies can fail to identify risks, miss out on valuable sales opportunities, and simply lack the ability to comprehensively oversee their operations. One key way companies are able to forecast their future performance accurately is through the implementation of financial modeling methods. But what exactly is financial modeling, what does it involve and how can companies execute it successfully?

What is financial modeling?

Financial modeling is the act of building a financial representation of a company by interpreting various features of its operations, such as accounts receivable, inventory and long term debt, which are mathematical simulations of real-world situations. The modeling process typically involves creating a summary of a business’s financial performance in Excel spreadsheets, which enables them to modify different variables to ascertain how changes may impact the company further down the line. Some examples of financial models include:

Sensitivity analysis model

This is a model designed to ask ‘what if?’ questions in order to test how sensitive a company is to changes in the market environment. For instance, they may wonder “what if my supplier costs rise by 25%?”, and how this would impact the business. So, a sensitivity analysis model would need to be able to adjust a ‘supplier cost’ variable, enabling the company to evaluate the effect of these rising costs on its operations. Sensitivity analysis tends to involve altering one variable at a time to ascertain its impact on the whole model in isolation.

Scenario analysis model

A scenario analysis model entails creating a scenario involving a number of different inputs or variables. For instance, a company might make three scenarios for the future: a ‘base case’, a ‘best case’ and a ‘worst case’ scenario. The latter could involve taking various key variables, analyzing whether the business could handle all of them performing badly over a designated period, with a best case scenario involving all of them performing well, and a base case scenario in the middle.

Budget model

As the name suggests, this model helps a business work out its budgets for an upcoming period. This involves breaking down expense categories in more detail, enabling a company to assign limits and control spending based on what it can afford. A budget model will not only help businesses understand how much they can spend, but when they can do so.

How to build a financial model in Excel

There are three main building blocks of a financial model in Excel:

  • Inputs
  • Processing
  • Outputs 

Inputs

Inputs are the data entered into an Excel financial model, eventually enabling it to produce outputs. Both inputs and outputs will include the names of the metrics which describe the data, such as expenses or gross profit, as well as the period it relates to, like a particular year or month. It is important to note that inputs must be clearly differentiated from the processing and outputs of a financial model to ensure that all data is accurate. A good way to do this is to use different colours for each.

Processing

The processing stage is simply about translating inputs into outputs, and companies will want to use Excel formulas to calculate the output data. Examples of formulas to utilize include:

FV

The FV (Future Value) formula simply works out the value of an asset after a certain period of time, based on regular payments and an assumed rate of growth.

PMT

The PMT (payment) formula calculates values for a loan with regular payments and a constant interest rate.

EFFECT

The EFFECT formula works out the effective interest rate — which takes the effects of compounding into account on top of the interest rate itself.

RATE

The RATE formula calculates the interest rate per period of an annuity.

DB

DB stands for Declining Balance, with the DB formula working out an asset’s depreciation expense over a specified period.

Outputs

The outputs are the products of processing, and represent the set of results from a financial model. They may be simple, such as the cost of a single product in a single cell, or a more complex table or chart, such as a balance sheet. It is recommended to always put the outputs into a separate spreadsheet for display purposes, allowing users to review them without having to trawl through the entire model.

Drawbacks of using Excel for financial modeling

While Excel is most commonly used for financial modeling — owing to its flexibility, convenience and highly sophisticated logic — a number of problems can arise. One of these is rendering a company’s proprietary data and intellectual property vulnerable. Because Excel files must be emailed and copied between individuals, it becomes difficult to control who has access to them, which can expose data to hackers.

Another drawback of Excel is version confusion, with multiple users often simultaneously working from different versions of a spreadsheet. This can result in individuals sharing out-of-date files, which can lead to the dissemination of inaccurate data. Meanwhile, Excel can also cause compatibility problems if users are working from different operating systems, or have mismatched versions of the software. This may leave them unable to use Excel properly, if at all.

How EASA can help with financial modeling

Considering how useful Excel is for financial modeling, it’s understandable that businesses will be hesitant to move away from the software, even with the multiple issues outlined above. Fortunately, with EASA software, they don’t have to. EASA allows businesses to webify their spreadsheets, creating web applications where the functionality of their spreadsheets is fully available with only a web browser, but without actually allowing users to come in direct contact with the Excel file itself. This resolves all of the problems listed above.

Keeps proprietary data and intellectual property safe

Because everybody will be working from one centralized web portal instead of separate spreadsheets, the need to download, edit, copy or email spreadsheets is eradicated. Removing this potentially dangerous practice helps prevent the exposure of intellectual property to unauthorized users.

Eradicates version confusion 

EASA prevents version confusion, as users can only access and edit the latest version of the underlying spreadsheet. Only the administrator can update this principal file, uploading a new version to the EASA system as necessary. In addition, multiple users can access the same version of a spreadsheet concurrently, without having to check in or out, and without the risk of overwriting somebody else’s work.

Prevents compatibility issues

Users only need a web browser and an internet link to a company’s secure servers via its network or the cloud to access the portal. As a result, they will not have to download any locally-installed software, or install Excel itself, preventing any issues around incompatibility with a user’s system.

Permits the inclusion of VBA, macros, add-ins and complex formula

EASA has the ability to include advanced functions such as VBA and macros which are frequently used in financial modeling spreadsheets.

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