The Magic of Financial Modelling

The Magic of Financial Modelling

I’ve come across a lot of preconceptions (and misconceptions) about the idea of financial modelling; many people think it sounds very elaborate and esoteric, even mystical. Some question whether the skill is a science or a creative tradecraft in the industry, and I’ve even heard suggestions that it’s a dark art! But what is financial modelling really – an art, science, or just plain magic?

A financial model takes a theoretical idea or problem and translates it into a practical construct we can use to see what might happen in the future. Like a crystal ball? Well, I suppose so, but it’s far more accurate! For example, you might be worried about business risk and want to know what will happen to profitability if costs from a particular supplier were to increase. You can build a model to represent the business and run scenarios to see how profitability might be affected if these costs were to increase. In this case, inputs are costs, volume and pricing, and outputs are profits. A good financial model has these inputs and outputs clearly defined and as we change the pricing inputs, the profitability projections will automatically change. Being able to perform simple scenarios or sensitivity analysis in a model like this, the instant information can really seem like magic. So Financial Modelling is magic then? Well no, not really. Once you know how it’s done, you can break it down into a set of processes and in the same way as a card trick, it can be taught!

Is Modelling an Art or a Science?

As there are many components that make up a financial model, the skills needed for financial modellingare many and varied. A modeller must be a good mathematician as well as someone who can think creatively and who possesses sound logic in order to pre-empt possible outcomes and make sound and reasonable assumptions about the business. Like a fortune teller, you need to be able to read the situation and ask the right questions, assess possible roadblocks and side-step potential pitfalls. A good modeller will not delve into unnecessary detail, knowing when to use rough estimates for assumptions, and when to perform precisely detailed calculations.

Simply put, the financial modeller must get the calculations correct, understanding the relationship between numbers, which data to collect, and be able to define and explain the assumptions made for future projections. There are also the considerations of other variables, such as stakeholder buy-in and the wider environment. How likely is it that the decision makers are going to change the growth rate assumptions over time? If not, a simple single input for growth will suffice. Otherwise, a separate input cell needs to be created for every single time period of the model, which makes the model more complex to build as well as audit and understand. A good financial modeller can make the trade-off between simplicity, clarity and sophistication or complexity and has the ability to see how their model fits into the bigger picture.

So are these artistic skills or scientific skills? In my opinion, they need both.

The scientific side of modelling is in quantifying the business performance, getting the mathematics correct and understanding the relationships between the quantitative data. In order to engage and motivate investors, the numbers must be accurate and clear. This, in basic terms, means ensuring that data used reflects the true situation clearly and concisely, and highlights the key information. Taking this approach shows that precision and complexity are key features of the financial model, and will evoke confidence to those viewing and using the model.

A financial modeller certainly needs a certain level of artistic skill for the aesthetic design and layout of a model. This is an area that many modellers and analysts struggle with, as aesthetics simply do not come naturally to left-brain thinkers like us. (Now, I know that this left brain / right brain theory has been largely debunked but I still think there’s something to it!) We are mostly so concerned with accuracy and functionality that we often fail to notice the way the model looks to someone else viewing it for the first time. Although it’s just a simple matter of taking our time when formatting, most of us could not be bothered with such trivial details as making models pretty, and consequently most models I see use the standard gridlines, font, and black-and-white colouring that are Excel defaults.

I’m certainly not suggesting that you embellish your models with garish colours, but you should take some pride in your model. I’d highly recommend that you spend a few moments to change the styles and formatting as you build the model so that it looks less like a clunky spreadsheet and more like a professional, reliable, well-crafted model you’ve taken your time over. Research shows that users have more confidence in models with aesthetically pleasing formatting than those without, so one of the fastest and easiest ways to give your model credibility is to simply spend a few minutes on the colours, font, layout, and design.

The artistic nature of a financial modeller is also needed when the model requires forecasting of future performance. Crystal ball gazing is probably not a skill that you possess, so you will need to spend some time thinking about how this is best done accurately. A set of assumptions must be made to make predictions or forecast outcomes in your model. 

No matter what else, the calculations within a model must be realistic and must consider mathematical principles as well as incorporating clever and logical guesswork. Like a good card trick, your audience will want to know how you achieved it, and unlike a magic show, you cannot keep your “tricks” to yourself! You need to be able to explain the magic (i.e. how you came up with the calculations) to continue the performance.


Danielle Stein Fairhurst is a financial modelling specialist trainer, author and consultant. View the full article here.

Ahmed Azmi , Msc ,CVA

VP International Investment at Kuwait Pillars for Financial Investment

6 年

Sure there is some of art and science within the process of building a financial model the more models we build or expose to, we realize more this is both of art and science

Ana Pimenta

Chief Impact Strategist @Blink | Board Member | PhD | Impact Investing and Strategy | Sustainability and Regeneration

7 年

Simplicity and complexity, art and science - great definition of financial modelling! Thanks for sharing

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Jennifer Harrison

??♀?Growth genie at your service! - My tradecraft is PR, media, marketing & comms - My focus is fintech, proptech and legaltech - My superpower is B2B sales enablement

7 年

Like! FM is definitely an underrated professional skill.

Michelle Lamarre Jackson

IT Project Manager at Cornell University

7 年

Yes! Yes! Yes!

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Will Wardle

Financial Modelling and Business Analysis

7 年

Great article. Financial modelling is both an art and a silence as many have said. The art improves the more models are built learning from experience. Good financial models do have one thing in common and that is simplicity. This simplicity is actually the more complicated part of it as it's a financial modeller to make the complex simple (or as far as it can). I have recently inherited a financial model built by one of the big 4 and on day 1 of my new assignment had to meet the model builders with only 4 hours to review and ask pertinent questions. Let’s say I wasn’t impressed with what they had done over a period of 4 months. They took the easy path and just re-built what the client had with all of its flaws without thinking about making it better and simpler

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