How to review a financial model?

Reviewing financial models

Basically there are several ways to review a financial model, mainly there is the analytical way and there is the technical as well as the mechanical way.

  1. The technical way. The hard way to review a financial model is to go through the model cell by cell and check the calculations or even redo them. However in most cases this is too time-consuming and therefore not realistic.Its normally done only to check crucial calculations which are at the heart of the model.
  2. The mechanical way. What one can do however is to insert automatic calculations inside the model added on a separate line, which checks if e.g. the totals are calculated correctly. E.g. if the balance sheet’s total assets equals to total liabilities and shareholder’s equity. One can extend those checks to other sections, especially by checking if the breakdowns reconcile to the totals. At the end, the differences can be summarized and on the executive summary a “Model Check” output can  be included. If the Model Check is zero, it means the model should be correct, if its something else it means there is a problem within the model. Such checks normally can capture quite a number of errors but will leave some aspects unchecked as for any standard model when trash is inputed, trash will be the output.
  3. This leads us to the analytical review. This works as follows: By varying the assumptions in an analytical way one checks if the model reacts in a way one would expect. One can take one of the output values such as the NPV of a DCF calculation and start varying assumption for assumption. If the model’s reaction appears to be plausible, then the model should be correct, if the reaction leads to unanswered questions, the model needs to be rechecked. Depending how much the NPV changes one can check back if that actually can be true. In case the difference to the previous value is too small / too big one can check back if the calculations are correct. Most of the time one will find new ways to calculate certain line items and in this way the model can be validated and improved.

So the review leads to questions which will be answered once those are worked through. This way one can actually learn quite fast how the financial model works. This is just to summarize the most common ways how to review a financial model.