Financial models are used for a number of reasons depending on the situation. All too often I see financial models being developed on the implicit assumption that they are to be used to analyse a project or transaction on a stand alone basis.
The analyst’s model vs. the reality of management
When taking a step back from the detailed view of an individual financial modeller or analyst it becomes clear that hardly any financial models are analysed on a pure stand-alone basis. In a vast majority of cases the output of a financial model will be rated against alternative projects, peer competitors or against alternative asset classes.
Rating one project/transaction vs peer comparison
When constructing a financial model for stand-alone analysis of one transaction it is a common argument that one can simply define key metrics as you see them fit. For example, if you only have pre-tax, real cashflows then it is a very simple solution of the analyst to present to management and pre-tax, real, IRR.
On a stand-alone basis, this doesn’t present any problems but when the IRR from the current project is benchmarked against peers or alternatives, then having a consistent definition is critical or management runs the risk of unknowingly pick the wrong projects or transactions to proceed with.
Create financial modelling standards and associated workbook templates
A very simple, yet effective, solution the problem stated above is to ensure that there are financial modelling standards in your organisation. Even something as simple as creating a standard template output sheet can make a huge difference for the consistency of outputs, and it will only take a good financial modeller a couple of hours to put together.
Suggested areas to focus on to ensure consistency (absolute minimum)
- IRR (pre/post tax, real/nominal)
- NPV (pre/post tax, real/nominal, calculation date)
- Cashflows (real/nominal)
- Assumptions (prices curves, CPI, expansion options, hedging, production, reserves, life of assets)
In short, the standard output sheet should include enough information to allow a reader to make an informed decision, and compare this to other transactions prepared in the same format.
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