Six reasons your spreadsheet is NOT a financial model
08 February, 2010
I’ve often been asked the difference between a spreadsheet and a financial model, and there is a fine line of definition between the two. In a nutshell, an Excel spreadsheet is simply the medium that we can use to create a financial model. (Of course there are other programs besides Excel that can be used for modelling, but that’s another story!)
At the most basic level, a financial model which has been built in Excel is simply a complex spreadsheet. The definition of a financial model is a structure which contains input data and outputs. By changing the input data, we can test the results of these changes on the output results, and this sort of sensitivity analysis is most easily done in an Excel spreadsheet.
Does it really matter if I call my spreadsheet a financial model?
One could argue then, that they are in fact the same thing; there is really no difference between a spreadsheet and a financial model. Additionally, does it really matter what we call them as long as they do the job? After all, both involve putting data into Excel, organising it, formatting, adding some formulas and creating some usable output. There are, however, some subtle differences to note.
- ‘Spreadsheet’ is a catchall term for any type of information stored in Excel, including a financial model. Therefore, a spreadsheet could really be anything – an item checklist, a raw data output from their accounting system, a beautifully laid out management report – or a financial model used to evaluate a new investment.
- A financial model is more structured. A model will contain a set of variable assumptions, inputs, outputs, calculations, scenarios and often includes a set of standard financial forecasts such as a profit and loss, balance sheet, and cash flow which are based on those assumptions.
- A financial model is dynamic. A model will contain variable inputs which, when changed, will impact the results of the model. A spreadsheet might simply be a report which aggregates information from other sources and assembles it in a useful presentation. It may contain a few formulas, such as a total at the bottom of a list of expenses, or average cash spent over 12 months, but the results will depend on direct inputs into those columns and rows. A financial model will always have built-in flexibility to explore different outcomes in all financial reports based on changing a few key inputs.
- A spreadsheet is usually static. Once a spreadsheet is complete, it often becomes a standalone report with no further changes to be made. A financial model, on the other hand, will always allow a user to change input variables to see the impact of these assumptions on the output of the model.
- A financial model will use relationships between several variables to create the financial report, and changing any or all of them will affect the output. For example, Revenue in Month 4 could be a result of Sales Price X Quantity Sold Prior Month X Monthly Growth in Quantities Sold. In this example, three factors come into play, and the end user can explore different mixes of all three to see the results and which reflects their business model best.
- A spreadsheet shows actual historical data, whereas a financial model contains hypothetical outcomes. A by-product of a well-built financial model is that we can easily use it to perform scenario and sensitivity analysis. What would happen if interest rates increase by half a basis point? How much can we discount before we start making a loss?
In conclusion, a financial model is really just a complex type of spreadsheet. The list of attributes above can identify the spreadsheet as a financial model, but in some cases we really are talking about the same thing. Take a look at the Excel files you are using. Are they dynamic, structured and flexible or have you simply created a direct input spreadsheet?