Operational Financial Model Techniques: How to Start Developing One for Your Company

Developing an Operational Financial Model (OFM) is a critical step for companies aiming to enhance performance monitoring and support operational decision-making. Unlike Classic Financial Models (CFMs) that focus primarily on investment decisions, OFMs offer real-time insights into company operations. They provide granular data essential for day-to-day management, reflecting the complexity and fluidity of organizational activities. This article outlines the key techniques for creating an effective OFM and shares practical steps to kickstart the development process.

Key Differences Between Classic Financial Models and Operational Financial Models

CFMs are designed to support high-level strategic decisions, such as evaluating investment opportunities. Typically, these models operate on a yearly basis and categorize data broadly, relying on aggregated P&L information. Updates are infrequent—annually or quarterly—and focus on overarching trends rather than detailed operational nuances.

OFMs, by contrast, are geared toward real-time performance analysis and operational decision-making. They:

• Operate on a monthly basis for more frequent insights.
• Provide granular data by cost item, product, or department.
• Incorporate actuals from the General Ledger (GL), and not from the reported P&L as in CFMs.
• Require collaboration between finance teams and departments to identify and address budget vs. actual variances.

This granular approach enables companies to analyze discrepancies deeply—identifying whether variances arise from activity cancellations, conservative budgeting, or postponed activities—and ensures accurate forecasts that reflect the true state of operations.

Steps to Develop an Operational Financial Model

1. Gather Key Sources and Define the Layout

To start, collect essential data sources:

• Detailed P&L Structure: Use the format presented in management accounts for Board/CEO/CFO reviews. This will form the backbone of your model.
• Current Year Budget: Ensure it aligns with the P&L structure.
• General Ledger Extract: Use historical data as a foundation for building and updating your model.

2. Structure the Model

Structuring the model is critical to ensuring functionality and scalability. Follow these steps:

1. Intro Sheet: Create a central control sheet with:
   • Reporting month and year (selectable via dropdown).
   • Variables and scenario switches.
2. P&L Sheets:
   • Add separate sheets for actual P&L, budget P&L, and budget corrections.
   • Maintain consistent layouts across these sheets to simplify data analysis and updates.

3. Scenario Sheet: The OFM, unlike the CFM, provides unlimited opportunities for scenario evaluations as the management may request the evaluation of any of their decision, not just sales increase or costs decrease. While CFMs typically explore high-level scenarios like changes in sales amounts by year, OFMs allow for far more detailed and dynamic assessments. For example, you can model an expansion scenario, including additional headcount (HC), equipment purchases, and their respective impacts on the P&L. Design the scenario sheet to include these variables and use a dynamic setup to facilitate updates without needing to alter the overall structure.

1. General Ledger Sheet:
   • Include GL data and add a mapping column to tag accounts or analytics (e.g., cost items) to P&L categories.
   • Automate mapping using formulas like VLOOKUP to ensure consistency.
2. Automation: Define periods as actual or forecast using formulas (e.g., IF statements) linked to the reporting month.
   • Use SUMIFS to aggregate data by mapped P&L items for actual and forecast periods.
3. Scenario Integration: Reflect scenario impacts dynamically in the forecast P&L, ensuring accurate inclusion or exclusion based on active or inactive scenarios.

3. Add Key Financial Statements

• Cash Flow (CF): Map CF data separately from the GL for actuals. For forecasts, derive CF from the P&L and Balance Sheet (BS).
• Balance Sheet: Ensure accuracy by incorporating working capital calculations (e.g., AP/AR days) and reconcile discrepancies between forecast and actual figures. For minor mismatches, automate adjustments as balancing figures.
• Summary Sheets: Create clear, concise summaries for Board presentations. These should include intro details, assumptions, and summaries of key data points.

Best Practices for Model Development

Developing an OFM is a meticulous process that requires careful attention to detail and adherence to best practices:

1. Advanced Excel Skills: Proficiency in Excel, including advanced formulas and automation techniques, is essential.
2. Avoid Hard Coding: Maintain consistency by keeping similar items in the same layout and using formulas instead of hard-coded values.
3. Trial Period: Validate the model during a trial period, comparing actuals with both budget and latest forecasts. Identify discrepancies and refine calculations accordingly.
4. Set Accuracy Targets: Establish performance benchmarks for the finance team to encourage continuous improvement in forecasting accuracy.
5. Version Control: Save copies of the model for each reporting month in a dedicated folder. Maintain the latest forecast for the upcoming month to ensure continuity.

Challenges and Benefits of an OFM

Creating an OFM is undoubtedly time-consuming. It requires:

• Significant upfront investment in time.
• Collaboration between departments to ensure accurate data inputs.
• Continuous updates and validations during initial implementation.

However, the long-term benefits outweigh these challenges. Once established, an OFM becomes a powerful tool for:

• Providing real-time insights into company performance.
• Supporting informed decision-making at all operational levels.
• Streamlining the budgeting and forecasting process.
• This solution is highly adaptable without necessity of the budget in contrast with existing software which often require extensive customization and the costs, moreover they lack the ability to dynamically integrate changes in a detailed and systematic way.
• This solution can integrate Power BI or other similar tools for visualizing results , or AIs tools for automating data inputs.

While the model may contain numerous sheets and appear complex, remember that its primary audience is internal teams. For the Board, only the intro, assumptions, and summary sheets will be shared, ensuring simplicity and clarity in high-level presentations.

FinDep Consult: Expertise You Can Trust

At FinDep Consult, we have extensive experience designing and implementing Operational Financial Models tailored to various industries. Our proven methodologies ensure robust, scalable, and user-friendly models that drive results. If your company needs assistance in developing an OFM or refining existing financial models, don’t hesitate to reach out to our team of experts.

Contact us today to elevate your financial modeling capabilities and empower your decision-making processes.