financial-modeling

# Financial modeling

A model is an argument about how the business works, expressed in arithmetic. Its value is the
argument, not the output precision.

## Structure

Three separated layers, always:

1. **Inputs** — every assumption, in one place, each with a source and a date. An assumption buried
   inside a formula is invisible and therefore never challenged.
2. **Calculations** — no hard-coded numbers. Ever. A constant inside a formula is an untraceable
   assumption.
3. **Outputs** — the statements and the summary a decision-maker actually reads.

One row, one calculation, carried consistently across periods. Models become unauditable through
inconsistent rows more than through complexity.

## Build revenue from drivers

Never grow a top-line by a percentage. Build it: volume × price, or accounts × retention ×
expansion. Driver-based models can be argued with, and being argued with is the point — a growth
rate cannot be wrong, only optimistic.

Cost structure separated into fixed, variable, and step-fixed. The step-fixed items are where plans
break, because they move in jumps nobody modeled.

## Sensitivities are the deliverable

A single-scenario model tells you nothing about risk. For every model, produce:

- **Which two or three assumptions actually move the answer.** Usually far fewer than expected.
- **Breakeven on each** — how wrong can this be before the decision reverses?
- **Downside case** — not a haircut on the base case, but a coherent story where things go badly.

If a plan only works in the base case, that is the finding.

## Reviewing someone else's model

The description of a model is not evidence about the model. Check these, in this order, because
each one invalidates everything after it.

- **Trace one number end to end.** Pick an output that matters and follow it back to inputs. If you
  cannot, nobody else has either, and the model has never actually been reviewed.
- **Find the hard-coded constants.** Search the calculation area for typed numbers. Each one is an
  assumption that escaped the input sheet, and they are where overrides hide.
- **Check the row consistency.** A formula that differs partway across a row is either a deliberate
  change nobody documented or an error, and the two look identical.
- **Test the extremes.** Set a key driver to zero and to double. Models frequently break, go
  negative in impossible ways, or fail to respond at all — which tells you the driver is decorative.
- **Check that the statements tie.** Cash flow reconciles to the balance sheet movement; the
  balance sheet balances in every period, not just the first.
- **Ask what is missing.** Working capital, hiring lag, churn, price changes, tax, and the step
  costs that come with growth are the omissions that flatter a plan most.

**Then find the assumption doing the work.** Most models rest on one or two numbers, and those are
usually the least evidenced. Ask where each came from and what it is based on — the answer is
frequently that it was chosen to make the case work, which is a fine thing to know before relying
on it.

## Presenting

Lead with the answer, then the two assumptions it rests on most heavily, then what would change it.
Never present a model without stating what it is most sensitive to — the recipient will assume
robustness you did not claim.

## Never

- Report a number to more precision than the assumptions support. Five significant figures from a
  guessed growth rate is false confidence.
- Build a model whose logic you cannot explain in three sentences.
- Change an assumption to reach a desired output without labeling it as a target case.