When building financial models, it is helpful to conceptualise the results that the financial model needs to produce and to work your way backwards from there. The following provides brief pointers on why this technique is useful and how it works.
According to the world-renowned leadership adviser, Dr Stephen R. Covey, an effective person always approaches a task or project by starting with the end in mind.
He says that having a crystal clear picture of what we want to achieve before we take the first steps will make it easier for us to determine what we need to do in order to reach that goal. In his international best-seller The 7 Habits of Highly Effective People, Dr Covey adopts the analogy of a building, pointing out that construction is only possible once the blueprints have been drawn up.
The habit of beginning a process of construction with a clear understanding of the end product can be highly beneficial when building financial models. When we can conceptualise how the model should function and appear, we can work our way backwards to see what steps are needed to achieve that result.
Here are some guidelines on how this approach can be applied to financial modelling and why it is beneficial:
Make sure the steps are clearly defined. When we begin with the expected output, each task that precedes it must be broken down into steps and arranged logically. These clearly defined steps tell us how far we are from the required result and, therefore, the time required to achieve that result.
Avoid unused calculations which do not add to the required output should be avoided completely. This approach is very helpful in models where we need to replicate. Start with the financial statements and then work backwards to find the inputs required to calculate the line items in the financial statements.
Don’t start with the inputs – as tempting as this is. This is important as we won’t know what data is needed unless we start with our outputs and figure out how to calculate each line item.
As with any new habit, adjusting your approach to building a financial model can take time. Starting with the end in mind may be difficult at first, but by persevering with this method and using it each time you need to build a model, you will soon find that it is an efficient and logical approach.