The prototyping stage forms an integral component of the financial modeler’s approach and is even more apparent in sophisticated environments like mergers, acquisitions or even capital budgeting. The focus of this stage is on the preparation of a first basic outline of the financial model, in order to test the concept, the logic and the general skeleton of the model prior to developing a much longer and detailed model. This paper provides an expert view of the process referred to as prototyping in financial modeling, its goals, components and recommended approaches.
What is Prototyping in Financial Modeling
Prototyping is an early stage in a financial model in which a model is developed around the broadest and simplest parts of the model that embody the architecture and the logic of the envisaged final model. Objectives are verified, assumptions are tested, practically assessing the adequacy of the proposed structure to achieve the objectives set forth by the owners. It’s a self-contained approach, but still a process where the model is built layer by layer from a general-financial picture to quite detailed elements with a feedback in the end.
Generally, the prototype consists of executive summary versions of the important financial statements (Income statement, Balancing figure, and Cash Flow) and cursory projections for certain parameters like the revenue growth and costs, capital outlay and interest rates. At this point, the prototype does not seek precision or comprehensiveness but aims to provide a starting point for the demonstration of the possibilities and the fit with the business objectives.
Prototyping Phase Key Goals
The financial modeling, prototyping stage has a number of objectives:
- Testing for Feasibility: The prototype goes a long way in determining the scope within which the finance model can be constructed in light of the data, business assumptions and goals of the model.
- Validation of the Model: In this phase the basic structure, core hypotheses and interdependence of financial determinants are evaluated with the intention of achieving the model’s purpose.
- Getting Feedback from Stakeholders: Usually the prototypes are handed over to the decision makers or stakeholders in order to get their opinions on the structural and basic assumptions before a full model is developed.
- Identification of Key Drivers: It helps to spot the most important operational and financial drivers of the business which in further modeling will have a maximum effect on its outcomes.
- Simplified Risk Identification: The shortcomings of early assumptions and the variables can be identified and controlled.
Steps in the Prototyping Stage
a. Define Objectives and Assumptions
In most models, the first step in prototype creation is properly stating the main goals of a financial model. For example, is the model being created in order to evaluate investment opportunity, assess project viability, or determine the worth of a business? Once the objectives are clear, the modeler articulates the key assumptions, which includes revenue growth rates, Cost structures, capital requirements among others.
b. Simplify the Structure
At this stage more or less the structural complexity of the financial models is in plain terms referred to a more simplified version. Modelers create first drafts of Income Statement, Balance Sheet and Cash Flow Statement, concentrating on their main constituents and ignoring detailed components that shall be incorporated later on. For example, revenue could be projected based on total sales where there is no distribution of revenue by products or geographical markets.
c. Initial Scenario Testing
A prototype helps run basic scenarios to assess the effect of variations in critical inputs of the model on the model outputs. For instance, modelers might increase or decrease the revenue growth rates or costs and find out what this would bring on profit or cash flow. This serves to establish whether the interrelationships amongst the variables are logically applicable and consistent with the business environment.
d. Integrate the feedback
Typically, at the completion stage of the construction of this model or a prototype, major stakeholders such as the CFO, an investment banker, or a project manager may be asked to review it. Comments are captured regarding the design, assumptions made, and the relationships formed in the model enabling such critics to help the modelers in refining this particular prototype before proceeding to the next level.
e. Enhance the Prototype
Following this, a prototype is then improved based on the comments and additional evaluation. This could involve changing some of the assumptions, changing some of the structures of the models, or introducing some new variables that were previously excluded. The objective here is to ensure that the final completed model will not be a rigid entity and will be expandable concerned the more detailed inputs and outputs which will come in the next phase.
Best Practices for the Prototyping Stage
a. Do Not Make It Complex
A reasonable assumption on why someone creates a prototype is not to achieve a complete financial model but to present something simple. Peripherally focus on the most important aspects and don’t make the structure overly complex.
b. Modular Approach
Crack the model down into little pieces and use the modular method for developing a prototype model. For example, first create separate modules for revenue, costs and capital expenditure, and later on link them all together. This also helps in not being restricted or held back during the testing phase should it be necessary to enhance or change certain elements.
c. Emphasize Design Drivers
In the process of designing and building models, users should concentrate during the development stages on finding and validating the most influential factors assuming financial outcomes for the business. For example, if the model aims for a retail business, testing revenue growth and the operating margins might be the most important factors.
d. Do Not Tolerate Extreme Optimism
During the stage of building prototypes it is always advisable to make conservative assumptions. This approach would augur well for the financial model and in particular framing the risk in the earliest possible stages. You can always revise assumptions as the model develops further.
e. Allow For Flexibility
Make sure that the prototype is flexible enough to make room for changes that may improve the design in terms of assumptions and variables that will be useful at the later stages. This flexibility will also make it possible for stakeholders to test different scenarios for example best case, worst case and most likely situations very easily.
Challenges in the Prototyping Stage
a. Data Availability
Data availability can be termed as one of the most critical problems especially during the prototyping stage when complete and/or accurate data is not easily available. Modelers are usually compelled to make approximations or assumptions that they know might be outdated when better data is acquired.
b. Overcomplicating the Model
One of the usual errors made is over designing the prototype and putting too many miscellaneous items into it at an early stage. This is against the essence of prototyping where the aim is to provide a basic sketch of the idea to be tested and then proceed to flesh the idea out further.
c. Aligning Stakeholder Expectations
It is possible for investment bankers and even CFO, etc. who are stakeholders in the process to hold completely different opinions in regard to the structure of the financial model or the outcomes expected from the model. Getting these expectations managed and synchronized is difficult but necessary for the modeling process to succeed.
Transiting from a Prototype Phase to a Diligent Model Making Phase
Once completed and refined, the prototype’s acceptance testing and validation become the basis for moving on to the next step forward which is to commence the making of the full model. This includes providing refinements to existing data and assumptions and extending the coverage of the model to take into account operational and financial dimensions. The experience gained during the prototyping exercise enhances the effectiveness of the full model by ensuring that it is fully functional, accurate, and appropriate for use in risk-spending scenarios.
Conclusion
Corroborating the Stage 1 building blocks of a Financial Model in this way ensures that there are a number of supporting documents that will conclusively form a structural element of the financial model constructed. It allows them to apply their theories and validate them before a more extensive and elaborate financial model is developed. Simplifying things, addressing the major drivers and raising the insights of affected parties, both in-house investment bankers and financial constructs will guarantee stick accuracy, flexibility as well as useful time as far as the making of decisions is concerned.
