Financial Modeling Code

 Finance is the lifeblood of any business. Every business organization needs finances to carry on its business activities.

We live in a world with fierce competition in the dynamic global market. Many bright entrepreneurs from underdeveloped nations cannot open their startups because they fear competitiveness and lack funding.

Now, let's focus on those businesses that have been running for a considerable time. As investors or stakeholders, we would be curious to know where the company is slated to be in the near future.

We know that the future can’t be predicted, but companies can make provisions for it. Financial modeling is a tool for deriving a mathematical representation of an organization’s financial situation so stakeholders can make informed decisions.

If all the major financial statements are properly accounted for, projected, and analyzed, an organization's current and potential financial situation can be assessed.

The building blocks of Financial Modelling are a company's financial statements, namely, 

1. Statement of Profit and Loss (Income Statement)
2. Balance Sheet (Position Statement)
3. Cash and Fund Flow Statements

 What is the Financial Modeling Code (FMC)?

The Financial Modeling Code (FMC) is a collection of guidelines and best practices for the creation of financial models that are free of errors, vigorous, and of the highest quality.

The systematic process of recording, summarizing, analyzing, and communicating financial information is known as accounting.

The International Accounting Standards Board has laid down the IFRS (International Financial Reporting System) to bring uniformity in accounting practices globally.

Similarly, the Financial Modeling Code (FMC) is a framework consisting of guidelines that govern the accurate and effective functioning of the financial modeling process.

Since this process is a crucial analytics and decision-making tool, FMC is vital in bringing uniformity. FMC guidelines also emphasize the financial data taken as a basis for financial modeling since incomplete and inaccurate data may limit the efficacy of this tool.

Here are some distinctive features of the FMCs for a better understanding:

1. Clarity, Consistency, and Transparency: The code expressly specifies that all financial models must be easy to understand, with all the assumptions being expressly mentioned as notes to the respective financial statements. Moreover, throughout the model, it also bats for the same set of methods to be used on reliable and accurate data.
2. Sensitivity Analysis: FMC emphasizes undertaking this analysis to determine how the various assumptions affect the organization's financial statements. This resembles the practice of simulation, wherein it is determined what the company's financial position would be if the assumption was considered and vice versa.
3. Accountability: Financial Models should be properly documented, along with expressly mentioning the source of data, methods applied, and assumptions made. This instills in the shareholders a sense of accountability and responsibility for the company.
4. Impartiality: The developed financial models shall be reviewed, validated, and tested by an independent third-party expert whose details may be produced by the organization for the stakeholders who would make various decisions based on such data.

Objectives of Financial Model Code (FMC)

Financial Models are the future and current projections of an organization's finances, which act as the fodder for financial modeling. 

FMCs are prepared with the primary objective of attaining standardization and uniformity in the financial modeling process, which will lead to an improved quality of decision-making. 

For instance, the main rationale of IFRS and ISA is to attain uniformity in global financial accounting and auditing practices, respectively.

The main objectives of the Financial Model Code are listed below:

1. Improved Quality of Financial Models: The guidelines are very particular about preparing financial models based on accurate, complete, and relevant data from reliable sources. This enhances the quality of the prepared models and decisions.
2. Risk Mitigation: FMC lays down many acceptable practices that financial modeler companies can adopt to construct accurate and reliable models.
3. Consistency and Comparability: The Financial Model Code applies the same set of methods to reliable and accurate data throughout the financial model. This facilitates consistency and comparability, thus leading to effective decision-making.
4. Facilitating Transparency: FMC promotes transparency by requiring financial models to be clear, easy to understand, and well-documented. This enhances the trustworthiness of the models and allows stakeholders to make informed decisions based on the model's output.

Key Aspects of Financial Model Code

By now, you must have understood that the Financial Model Code (FMC) is a framework that companies follow to ensure that the financial models they develop are uniform in format and comparable, thus aiding informed financial decisions. 

The primary focus of the FMC lies in the following areas:

1. Model Development: Guidelines are laid on selecting appropriate data sources, using consistent methodologies, and incorporating sensitivity analysis while preparing the models.
2. Model Documentation: To facilitate transparency and understanding among stakeholders, FMC requires the models to be properly documented along with the source of data, the methodology used, and the various assumptions made.
3. Model Testing: The risk associated with financial modeling has to be mitigated by testing and validating the models by registered independent reviewers so that the accuracy and reliability of the model remain unaffected.
4. Model Maintenance: Like any other financial analysis tool, FMCs ensure that future projections are constantly scrutinized and reviewed in light of ever-changing market conditions.

Types of Financial Model Code

Well, the list is long due to the vast and dynamic nature of the corporate world. Yet, let me list the most common ones.

​​​​1. Internal FMC 

These guidelines provide a level of control and flexibility to the company over its financial models as the organization develops and implements the FMCs. However, their preparation and formulation can be customized to fit business needs.

2. Industry-Specific FMC

Every organization is a part of some industry. This type of FMC is prepared for the entire industry (like banking, telecom, and real estate), and all the organizations look up to it while preparing their respective models. Intra-industry comparability, standardization, consistency, and accuracy in financial models are thus the rationale of this type of FMC.

3. Regulatory FMC

Regulatory bodies design, develop, and enforce these guidelines to ensure compliance with regulatory requirements and standards.

E.g., the Securities and Exchange Commission (SEC) of the United States lays down certain rules to increase transparency and accountability in financial reporting.

These FMCs are generally strictly adhered to by all corporations under such body’s jurisdiction. 

4. Open-source FMC

Under this method, guidelines are devised by a group of experts after thoughtful deliberation on the financial reporting process. After they devise the FMC, it is made available for the general public to join hands and collaborate with them. Thus, sharing the best and most suitable practices is made possible.

5. Hybrid FMC

Unlike other types of financial model codes, this type offers more flexibility and control to corporations as it combines all the elements of internal, industry-specific, and regulatory FMCs.

6. Enterprise FMC

These are laid down and implemented by large organizations with complex financial modeling needs. They are quite similar to Internal FMC, but the only distinction is that they can deal with big business houses' humongous size and complexity.

7. Template FMC

It is quite a time-saving, cost-efficient, and easy-to-use approach, offering straight-jacket guidelines for financial reporting. Here, a pre-built framework for financial modeling can be customized and modified to fit the nature and type of business. 

Spreadsheet software, such as Microsoft Excel or Google Sheets, is extensively utilized to develop financial models in a familiar and user-friendly interface. 

8. Academic FMC

These are the guidelines that academic institutions and researchers follow for financial modeling education and research development.

Academic FMC offers a standardized approach to the foundation for developing practical financial modeling skills for intra-firm and inter-firm comparisons. 

Application of FMC in real life

You must have understood that financial modeling is the building block of financial analysis. FMC aims to standardize these financial models, which the financial analysts of various enterprises prepare. Hence, their application is quite broad and diverse.

Banks make extensive use of financial models. Thus, FMCs for credit risk valuations in specific.

FMC guidelines help the company follow best practices by promoting transparency, accuracy, and standardization. As a result, financial models can reduce the extent of financial risk and support better and more informed decision-making. 

Key areas where FMCs generally focus are:

1. Investment Risk analysis: This involves assessing investment opportunities, estimating returns, and analyzing risk. Moreover, FMC guidelines strive to promote best practices and guidelines that reduce the risk associated with financial modeling.
2. Business Valuation: FMC guidelines provide a standardized rubric for determining a business's correct, fair, and justified value. Useful in cases of acquisitions and mergers. 
3. Budgeting and Project Finance: These guidelines facilitate the forecasting of the organization’s revenues, expenses, and cash flows, which are essential for budgeting and forecasting. Moreover, they provide a standardized vision of analyzing project feasibility and estimating associated costs.
4. Financial and Strategic planning: FMC guidelines support strategic planning detrimental to any organization's survival in the long run and maintaining its competitive edge. Moreover, accurate and reliable financial statements are a basis for safe financial planning.

Pros & Cons of Financial Model Code

Financial Modelling is about making projections about the organization's future state, which is derived from a critical analysis of all its major financial statements. Projections enable the users of financial statements to have a synoptic view of the company’s future position.

Though they fail to provide the exact position the company can find itself in, if they are done using proper data and methods, the future can be predicted to a certain extent.

FMCs try to control and curb the inefficiencies associated with financial modeling.
However, like any other analytical tool, deploying this metric has pros and cons.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Financial Modeling Tools
• Forecasting Balance Sheet Items in a Financial Model
• Types of Financial Models
• Unlevered Free Cash Flow (UFCF)
• Valuation Modeling in Excel