Common Financial Modelling Mistakes & How To Avoid Them

Introduction

The process of financial modeling involves the evaluation and analysis of an organization's historical and current financial data to project the future and accordingly make essential business decisions. The decision may be related to investment, restructuring and expansion, capital raising, bringing about operational changes, etc.

Since this procedure is useful for both the management and company stakeholders, it is important to ensure that it is error-free and transparent in providing correct and updated information as received from the verifying authority. Before the received data is interpreted and accessed by the internal and external stakeholders, it is necessary to confirm that the results are accurate. While exploring the process with our best financial modeling course will help enhance your knowledge, this blog will allow you to learn about the common mistakes that may occur during the creation of financial models.

• Common financial modeling mistakes are the errors that any modeler makes while designing any financial model.
• Analysts use such models for analysis and evaluation of the business, and any error will result in an incorrect estimation of the financial health of the company.
• Modelers should avoid such mistakes because they not only misguide the user but also make the process tough to understand and interpret, which will not serve the ultimate purpose of the work. 

Financial Modeling Error Categories

The categories of financial modeling mistakes committed while creating the models can vary a lot, depending on the skill and ability of individuals creating the model. It is essential that the professional handles transactions and deals with the financial data necessary to create the model during different operational processes because this will help in acquiring practical experience that can be used while making projections.

However, some standard types of financial modeling mistakes one may make are as follows:

• Conceptual error – Many times, we are not very sure or confident of the primary purpose of creating the model. Incorrect or vague understanding of the primary purpose leads to deviation from the goal. This is very critical and undesirable because apart from the wastage of valuable time and effort, the professional also loses focus of the work, making it tiresome and monotonous. Moreover, the business does not gain any valuable insight from it that will help in making future decisions or give an accurate picture of the company’s financial performance to its stakeholders.
• Structural errors – Every model follows a structure that explains the purpose and method or approach with clarity. There are various assumptions as well as actual information that we should use to make it easy to interpret and in line with real-life scenarios. Thus, errors of any kind in these areas, where proper assumptions are not in place or there is no synchronized data, lead to the designing of structurally incorrect models.
• Calculation errors – Calculation errors are financial modeling mistakes that are very critical and misguide the user of the model in a big way. This can happen when there is usage of incorrect formula, incorrect cells or values are picked up that should not be a part of the calculation, or the individual creating the model hardcodes the incorrect formula or value, etc. When wrong ingredients become a part of the calculation, the output is not acceptable because it may end up projecting just opposite results or scenarios.

Thus, if we remember the above financial modeling mistakes and sharpen our skills in the best way possible to minimize or keep no room for the above errors, we end up achieving the primary purpose of financial modeling and learning to use financial modeling and represent the organization through a comprehensive report, using reliable and accurate data.

p.s - You can checkout Financial Modeling course where we offer 12+ hours of high-quality video tutorial on Financial Modeling. Here you will learn McDonald’s Step by Step Financial Modeling from Scratch

10 Common Mistakes In Financial Modeling And How to Avoid Them

This part of the blog explains ten common financial modeling mistakes that one may make during the process, along with the steps that we should take to avoid them strictly.

1. Lack of planning

Planning involves identifying the actual users, the purpose of using the model, and its future scope in other relevant areas of the market. While making the model, you should have the urge to do thorough research on the topic, collect relevant and critical data, understand the components required, and then start the process. Just try to visualize how you would plan to cook a tasty dish on a special family occasion that everyone would love and enjoy. You will conduct research on it, refer to cookery books, videos, and blogs, speak to expert cooks about the best ingredients, try to judge the taste and preference of the invitees, etc.

Thus, to avoid such financial modeling mistakes, use that same approach and identify users, problems, and requirements that will give the model a purpose. Do proper market research, conduct company research, and collect authentic information, refer to relevant information sources, not just the ones that would give a short-cut and easy method to finish the job fast. Plan the structure with adequate commitment and interest.

2. No logical structure

It is essential to have a properly structured model. Since most financial models are designed in Excel, they will contain many sheets that will portray various types of analysis and steps, which will ultimately lead to the outcome. Unfortunately, many of us are not able to understand how to arrange the sheets one after another so that the user can understand the approach, leading to financial modeling mistakes. A jumbled-up set of documents is dangerous because even though the content is correct, the user has already lost faith in the model since the very first appearance, portraying a lack of effort and commitment.

So, what should you do to make your model structurally attractive? Follow a structure that is not only logical but also consistent and reliable. There should be a natural flow from one sheet to another, and when someone tries to read it, they should feel that you have made their complicated task very easy and their lack of financial knowledge does not hinder their understanding levels. However, we can get better clarity by learning the process using the financial modeling training course.

3. Complexity levels

Do you think that a complex model, stuffed with huge formulas and assumptions, will increase its credibility in the market? Will stakeholders rate your model and the company's performance at an esteemed level? Not at all. On the contrary, not only will you consume more time creating it, but you will also end up with mistakes and errors that someone can quickly identify.

Therefore, keep in mind that to minimize financial modeling mistakes, the formula should not be so long that it exceeds the length of the formula bar by even half. Select simple steps to perform the calculation and also add steps that will automatically crosscheck any misrepresentation of data and calculation errors. So, remember, the display of skills through complicated approaches will not increase the worth of your model.

4. Use of hard-coded values

Which is a more manageable approach? Typing values and formulas in cells manually each time or using the appropriate cell numbers to identify the values that are actually entered in one particular sheet, and the rest of the sheets automatically link with it?  The hardcoding process is a typical approach for inexperienced professionals who wish to save time. However, since there are hard-coded values that will not update by themselves, modelers do not realize that any slight change in any part of the model or assumptions will lead to a massive effort of manually making all the changes. Therefore, follow the good practice of avoiding hard coding and adopt the approach of an experienced and skilled professional who does brilliant work with accuracy and confidence.

5. Use of names

This approach definitely makes the process complex and minimizes financial modeling mistakes because the modelers try to keep it simple by giving names to cells. However, it becomes necessary to know the location of the named cell and remember it. You may find that you have filled your model with such names that are confusing and hard to detect. Therefore, it is better not to take that approach and keep it simple.

6. Hidden rows/columns

What is the use of hiding important information that forms a part of the calculation, and should you ideally display it for clarity? Obviously, it has no use. So, then, why do you feel the need to hide rows and columns? It may make the Excel sheet look clean and less complicated, but since an integral part of the step is hidden, the reader will not be able to relate the calculations. So, as modelers, we should not worry about the look but concentrate on clarity and transparency.

7. Integration of sheets/ calculation

This is, again, an error that many of us tend to commit while designing a model. We try to minimize the usage of essential parts of financial statements like cash flow or parts of the balance sheet, which provide valuable insight into the financial condition of the business. Trying to keep it simple by isolating essential data will not make it worthwhile. Instead, understand the importance of each part of financial information and integrate it as and when required.

8. Changing approaches

Modelers may, quite often, prefer to experiment with different approaches, formats, or structures and identify which will work best. They might bring changes based on the type of sector or industry, the category of users who will refer to the model, the purpose of creating it, and so on. However, this is not a good idea because it creates financial modeling mistakes through inconsistencies in the procedure. Therefore, it is wise to follow one proper method that we can apply to all kinds of models.

9. Unorganized look

When you look at two reports related to financial data of the same company, but one of them is written in a standard text format, without any highlighted heading, no proper side headings, final values not in bold, inconsistent fonts, no proper footnotes mentioning necessary assumptions or information, etc, and another report has all of the above, with proper labeling, indexing, use of colors for highlighting, and so on, which one would you choose first? Thus, it is essential to create each sheet in an organized way that will help the reader identify the required information quickly.

10. Giving half-hearted effort

Any work will be able to achieve its objective if the individual does it with maximum commitment and an aim to make it useful and serve the actual purpose. Remember, innumerable resources help create the model, among which time, research, financial knowledge, and skill are worth mentioning. Then why should such a valuable resource go to waste without proper utilization?  The creator of the model should always keep this in mind.

Hence, the above are some common financial modeling mistakes that modelers often make during their work process, and they should rectify themselves so that they can move ahead in their careers through the betterment of their expertise.

Importance

It is important to control and minimize the above financial modeling mistakes for the following reasons:

• It creates a sense of reliability and helps investors and other stakeholders who refer to this information gain faith and trust in the financial health of the company.
• It is the most important and comprehensive source of financial information for the management, who use it to plan for their business-related investments and expansion projects.
• It is also useful to keep track of the various strategies that the management has implemented for the betterment of the operational procedures and how well they are performed so that the management can take necessary steps for correction.
• A well-made financial model gives a fruitful and easy-to-understand user experience that gives correct information about the company and its market performance. If all is good, then the business will be able to get good funding from investors, which will help in growth and expansion.

Frequently Asked Questions (FAQs)

Recommended Articles

This article has been a guide to Common Financial Modelling Mistakes. Here, we explain the 10 common mistakes, its categories, ways to avoid them & its importance. You may also find some useful articles here -

• How Financial Modeling Can Boost Your Career
• Financial Modeling In Excel
• Financial Modeling & Valuation