Forecasting skills doesn't guarantee good modeling skills

Introduction

Just because you can drive a car doesn't mean you can be a Formula 1 race car driver.

Playing T20 cricket doesn't guarantee you will be a great test cricketer.

The same goes for forecasting and financial modeling.

Let's start from the beginning.

Shortly after leaving investment banking corporate finance, where my financial models produced forecasts for investors or shareholders and needed to be audited, I joined a traditional finance team. 

One day, as the finance business partner, I was debating the concept of financial modelling with one of the FPA team leaders.

A claim was made that as a result of building many forecasts this would naturally mean he had lots of financial modelling skills. .... (no auditor had ever checked those forecasts, so there are bound to be errors....there always are unless its audited...and even then its not guaranteed.)

However, I had a different view. 

He had certainly developed the ability to build a forecast spreadsheet but could he actually build a good (dynamic) financial model with multiple scenarios and simulations? 

Whilst I agree there are certain skills that are similar, there are still many gaps that most are not even aware of.

So lets really define the spreadsheet in comparison to a financial model.

Forecasting vs Modeling

In my experience having reviewed many forecasts produced by finance professionals including members of my own team, I noticed the following common differences between a good financial model and a forecast spreadsheet.

Lets compare simply

Structure

Finance Forecast

Difficult to see any formal structure in the models, especially when wanting to understand where you might find the assumptions to the model and the key outputs, KPIs etc. Its difficult to see where it started and ended.

I have seen very limited examples of a really good finance forecasts built like a financial model.

It's like walking to someone's house and you've walking through the garden at the back and you just don't know where to find the toilets or where the people hangout.

Financial Model

The financial model has clearly delineated assumptions and outputs.

It may even have navigation links (hyperlinks) in a table of contents to make it really easy.

Ease of navigation and whilst there might be different styles applied, it is important to show on a "cellular" level the assumptions and outputs should be easily visible.

Formulas

Finance Forecast

In the finance spreadsheets the formulas are often hard-coded values and seldom will they be consistent horizontally.

Financial Model

In the financial model this is a rule that is never broken.

Formulas are always written on a consistent horizontal basis to enable flexibility of logic.

If hardcoded it renders it model inflexible which is one of the pivotal parameters of a good financial model.

Error detection and prevention

Finance Forecast

A finance spreadsheet will seldom have error detection and definitely in very very few circumstances error prevention.

I have seen some error detection in spreadsheets, but hardly any (less than 1% have I seen with error prevention, like data validation.

Financial Model

All good models have lots of error detection (the more the better). Its like adding all these safety belts, airbags and many more to your racing car.

Some really good ones come with built prevention so you cannot even make an error even if you tried.

Its like your breatherliser test built into the car that says you are too tipsy to be allowed to change this model.

Scenario management, simulations and sensitivities

Finance Forecast

The purpose of a finance forecast generally doesnt include scenario management and simulation is unheard of. Happy to hear otherwise.

The purpose of a finance forecast is to get a forecast which becomes the budget for the following year...or perhaps in some quarters an update or quarterly business review.

There's a lot of pressure, with lots of stakeholders and it's not possible to always add this very important step to the budgeting and forecasting process.

It takes too long and generally there is limited strong skills that can build something like that robustly.

Financial Model

The entire purpose of building a financial model is absolutely to do scenario analysis and sensitivities as well as Monte Carlo simulation.

The whole purpose of building the model is it's the engine to your financial decision making, so this is highly valuable.

Value Drivers (driver based) vs Growth rates (run-rate based)

Finance Forecast

Because a finance spreadsheet is not built for the purposes of doing scenario analysis, but really to get lots of people to agree to a number (including the board), the value drivers are often left out.

Shortcuts to get to the forecast are put in its place and the output (often top down) It given as the outcome others need to work out to achieve.

Its like building the building and then asking the architect to draw it. That sounds like a really stupid idea.

Financial Model

All good financial models are built from the ground up based on the detailed drivers, not just the past results.

Building a model with actual value drivers that you can go back test and also look at the accruracy of those drivers (you unlikely to get it correct the first time) is the best result as the model improves in accuracy over time.

Graphs, charts and other outputs

Finance Forecast

Very few finance forecast actually have a lot of graphs and outputs

Seldom do people recognise that a chart can actually show accuracy of the model and be very useful, not just pretty pictures for a deck.

Financial Model

In many, if not all cases, a financial model is built with charts as a means of using them as a sniff test mechanism and for some pretty pictures.

Whether it's cash going backwards or certain key ratios, it's important to know whether those go out of a certain tolerances graphically.

User instructions or guide like a table of contents

Finance Forecast

If you dont have the luxury of someone waking you through the spreadsheet succinctly, you wont even have a map or understanding of where you going.

It can feel like you have dropped in the middle of the desert not sure which way to go to the oasis.

Financial Model

Financial modelers take a lot of pride in their work.

A financial modeler will build a model in a way that the experience is plesent.

Nice visibly appealing and interactive, like a great host with easy-to-navigate structure and table of contents with hyperlinks.

They really make it easy for you to enjoy your time while you understand what the models is currently modelling and forecasting for the future.

Conclusion

If you want to learn more in 2019 and also understand how you can upskill in FM be sure to reach out to us or stay tuned.

I encourage you to also take a peak at my past articles on financial modeling which is the foundation of business decision making, planning and forecasting.

We have also redesigned our website to help you along your journey of levelling up in this space.

We will continue to discuss this topic and you can click to follow me on Twitter or LinkedIn or subscribe to our short but sweet newsletter.

Be sure to check out our pods and video page.

Here are also some past blogs that might be of interest.

Excel is dead!

Why I disrupted my own role and you should do the same?

Your Financial Model can save lives!

Why financial modelling skills will be a big career door opener for emerging accounting and finance talent.

The Demand for Financial Modeling Skills Reaches new Heights

Data Analytics / Big Data is not Financial Modeling

Do You Model Off against the Masters of Financial Modelling?

Virtual CFO the Good, Bad and the Ugly

Lance Rubin is the Founder of Model Citizn, partner of theOutperformer, approved training provider to the Financial Modeling Institute and Group CFO for SequelCFO.

I have more than 20 years of combined experience working in model audit, investment banking, corporate finance, finance business partner and Fintech CFO.

Organisations I have worked with include PwC, KPMG, National Australia Bank, Investec Bank and Banjo small business lender.

I have a YouTube channel dedicates to the Future of Financial Modeling and also provide access to Models via Eloquens with thousands of viewers and downloads.