Whilst there isn’t one agreed-upon ‘best’ methodology when it comes to project finance financial modelling, there is widespread agreement on what constitutes good modelling practice, and probably without exception many experts would recognise and accept the three principles described here. These principles help you mitigate the risk of error and increase the level of assurance you can provide to model sponsors and users.
Three key project finance financial modelling principles to remember and apply:
1. The Principle of Error Reduction
2. The Feedback Principle
3. The Top-Down Approach
1. Principle of Error Reduction – quality assurance and quality control
This principle of error reduction is a simple concept based on our own experience and that of others in the business, where we recognise that certain modelling operations are more error-prone than others.
I believe in adopting a pragmatic approach that accepts that errors are inevitable and seeks to minimise their occurrence and enhance their detection.
The principle of error reduction forces us to recognise the inherent limitations of the spreadsheet model (and perhaps the modellers themselves), and to implement a framework which provides the resources and controls to minimise or mitigate the whole process of model specification, development, testing and use.
2. The Feedback Principle – a fundamental part of the quality control framework
The feedback principle means that we actively seek to test and validate our work continuously throughout the modelling process.
We use both positive and negative feedback – the former is the system of checks and controls we impose in order to detect and remedy problems in our models; the latter is that received from others (such as auditors) who have found errors in our work.
To obtain feedback we implement a number of feedback controls, which can be elements such as the audit workbook and report, the internal audit sheet and the various checks and test carried out during model development and use, and the use of peer review and external audit.
3. The Top-Down Principle – retain a view of the model’s overall purpose
The top down principle helps us make sense of the complexities of the modelling environment. Rather than becoming immersed in immense amounts of detail (bottom-up), we retain a view of the model’s overall purpose and results.
The audit profession refers to two approaches to audit: ‘controls testing’ and ‘substantive testing’, and this is essentially what the top-down principle provides – the key results are the controls; if they look reasonable then we can be selective in our choice of substantive tests to run, rather than analyse each formula in turn. In reviewing a 50Mb spreadsheet our immediate concern is that the key results are correct; we are less concerned with layout, hidden content or bizarre formulas.
• The three principles of Error Reduction, Feedback and the Top-Down approach allow you to mitigate the risk of errors with appropriate systems and controls.
• Structure your model by content: inputs, workings, outputs.
• Keep formulas short.
• Consider using an audit sheet to record the tests and checks in your model.
• Accept that errors are inevitable, and use methods and techniques that serve to minimise their occurrence and enhance their detection.
• Never forget the model’s overall purpose and results – and who will be using it.
If you are looking to brush up on your modelling skills please take a look at our in-house training courses here.