This series of articles will give you an overview of how to manage spreadsheet risk. These articles are written by Myles Arnott from Excel Audit
- Part 1: An Introduction to managing spreadsheet risk
- Part 2: How companies can manage their spreadsheet risk
- Part 3: Excel’s auditing functions
- Part 4: Using external software packages to manage your spreadsheet risk
In the first article in this series we highlighted the risks that poorly managed spreadsheet solutions can introduce to a business. In this article we will demonstrate how companies can manage this risk.
A formal governance framework
The first, and arguably most important step is to ensure that the senior management team buy into the need for a robust spreadsheet risk management framework, and that they define and effectively communicate their spreadsheet risk management policy.
Spreadsheets identified and catalogued
It is impossible to know the level of spreadsheet risk in an organization without first identifying and then risk assessing all of the spreadsheets. It is therefore necessary to create a catalog of all of the spreadsheets and then to gather the key information about each spreadsheet to enable a risk assessment to be carried out.
The two key factors for determining the spreadsheet risk are the probability of there being an error and the impact that that error could have.
Risk = Probability of an error X impact if an error were to occur
The probability of error is related to the complexity of the spreadsheet. Complexity attributes differ across companies but include:
- Spreadsheet size (Mbs)
- Spreadsheet design (hard coded numbers in formulae, poor model structuring etc)
- The number of users
- The use of complex formulae (particularly array formulae, nested formulae etc)
- The number of cells populated
- The number of internal and external links
- The use of VBA
The impact of the error is related to how critical the spreadsheet is within the business. Each company will have a slightly different definition of the impact levels of spreadsheets, but generally:
- A spreadsheet is low impact if it is not used as part of a critical business process and an error would not have a material impact on the business.
- A spreadsheet is medium impact if it contains confidential information and an error could have a material impact on the business.
- A spreadsheet is high impact if it contains highly confidential information and an error would have a significant impact on the business. Spreadsheets used within processes that fall under external regulation (such as Sarbanes-Oxley and Solvency II) are deemed to be of high impact.
Finally, the spreadsheets should be placed in order of risk. Those identified as business critical and high risk should be prioritized for detailed review and placed under control.
This is clearly an on-going process. As new spreadsheets are developed they will need to pass through the risk assessment process as defined by the company’s spreadsheet risk management policy. A periodic review should also be carried out to ensure that all spreadsheets have been correctly categorized.
A best practice standard
The company should define its own best practice spreadsheet development standard that is applied to spreadsheets deemed to be medium or high impact. The standard should clearly outline the standards and conventions to which a spreadsheet should be built. New developments can then be reviewed to ensure that they adhere to the standard.
We advocate the use of the Excel Best Practice Standard from the Spreadsheet Standards Review Board (‘SSRB’).
We also recommend that tailored schedules are added to the standard to reflect your specific design standards. For example this could be a specific color scheme, use of logo or the use of specific text within the header or footer (e.g. document security levels).
Testing
A fundamental, but often overlooked step in the Excel model development cycle is testing. All spreadsheets (but especially business critical spreadsheets) need to be first peer reviewed and then rigorously tested.
It helps to consider the steps that an IT department would take to ensure that something they deliver is correct. It will pass through stages of unit and system testing prior to quality assurance and finally user acceptance testing. So why should a spreadsheet being used for a critical process be any different?
The fact is that no matter how hard we try, humans make errors. The purpose of testing is to identify them and get them resolved before the model goes into the live environment.
Remember that in the first article we highlighted the fact that 94% of spreadsheets and 5% of all formulae within spreadsheets contain errors.
Here is Scott Adams’ view on spreadsheet testing in Dilbert
Training
All staff should be trained so that they have sufficient Excel knowledge for their role and to use the spreadsheets that they are responsible for. As part of the induction process all staff should also be taught the company’s best practice standard.
Whilst this sounds obvious, research has shown that few companies prioritize investment in spreadsheet training.
Documentation
A key risk with spreadsheets is that they are often built and used by one individual within a team (often referred to as a “key man dependency”). If this person is ill or leaves unexpectedly the other members are totally reliant on the documentation left behind. From experience this rarely exists.
Each spreadsheet that is used within a process should as a bare minimum have documentation stating:
- the purpose of the spreadsheet;
- how the spreadsheet fits within the process;
- the source of all inputs for the spreadsheet;
- all key assumptions and drivers;
- key calculations;
- distribution list for outputs.
Spreadsheets that are part of as critical business process should have detailed documentation. This should include a technical specification and user notes.
Security
All business critical and confidential spreadsheets should be subject to access control. Security controls can be implemented across three levels:
- Directory level: Only specific individuals have access to key directories
- File level: Confidential and critical spreadsheets should be password protected to restrict access
- Cell level: Non-input cells should be password protected
Change control, backups and archives
To minimize the risk of losing the current version of a spreadsheet and ensuring that the correct version is being used at all times, all business critical spreadsheets should be backed up, archived and subject to change control procedures.
So, in summary..,
the characteristics of a well-managed environment are:
- a formal governance framework, sponsored by the senior management team, is in place for all spreadsheet development;
- a catalog of spreadsheets is maintained and prioritized by risk profile;
- a best practice standard is applied to the development of all new spreadsheets;
- all new spreadsheets pass through a formal risk assessment, are peer reviewed and formally tested;
- staff are provided with sufficient training to carry out their roles;
- all spreadsheets and their associated processes are well documented;
- access to critical spreadsheets is subject to security controls;
- spreadsheets are subject to change control and are regularly backed up and archived.
What next?
In the next article we will look at the built in Excel functions that can help you to manage spreadsheet risk.
What about you?
How do you (or your company) manage spreadsheet risk? What best practices & guidelines you follow? Please share using comments.
Thank you Myles
Many thanks to Myles for writing this series. Your experience in this area is invaluable. If you enjoy this series, drop a note of thanks to Myles thru comments. You can also reach him at Excel Audit or his linkedin profile.
62 Responses to “Introduction to Financial Modeling using Excel [Part 1 of 6]”
Oooh! Chandoo - are you looking to outperform the Altman Z-Score?
I'm all ears 😉
Many thanks, Paramdeep. Looking forward to the remaining parts of the series
Thank you Paramdeep. I look forward to following the series.
Those interested in Financial Modelling may also find this site interesting:
http://www.fimodo.com/
Hi Chandoo,
Really looking forward for this awesome financial modeling journey 🙂
All the very best..
Regards
Rohit1409
Hi Chandoo,
it seems the future is not away when we will have a new software/spreadsheet as competitor to Microsoft Office/Linux etc.......Hats Off to you..
KEEP SMILING
GURU
@apex, clarity: Thanks...
@all: I do hope that you have started creating the model for the simple case given.. Lets see, what according to you all is the best way forward. So your views on the best practices for the template for valuation?
The planning process varies depending on the project and type of data I am looking at.
If I am doing a cost impact study based on actuals, verses a cost impact study to estimate future cost, verses reviewing historical data then creating a model, verse having to review historical data, apply it to a draft model, update the model based on the draft outputs and the presentation then sometimes repeat the process a few times.
Revisions are an absolutely necessary part of corporate financial modeling especially for the presentation sections. A good presentation will be revised multiple time. There are just to many elements which cannot be planned for, especially with ad hoc reports/models.
Revisions are leading cause of errors, and time spent tracking down errors. The more complex the model the more important revision control is. I would be interested in a section on revision control and good methodologies to determine the effect of changes on models. That is without having to due detail review of the whole model over again.
Hi Paramdeep,
I can't wait for the continuation of this series. You have done a great job in making technical terms appear simple and easy to understand. This article is also very useful in our line of business, in fact i will be featuring this article in our site. Of course the credits will go out to you.
Many thanks and keep it up!
Drew
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@Drew: Thanks! Hope that you found the tutorials useful. Feel free to get back with any queries.
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chando bhai i m tired for looking financial modeling detail but i cant find it anyway. so plz kindly send me full detail of financial modeling from beginning levelo to final. where i learn complete modeling procedure n order to become professional
You noob, you won`t become a professional like that, you need to do it on your own and learn as you go
@Nadeem Bhai,
The 6 links to the tutorial at the top of this post, build a small integrated financial model step by step. We are also running a complete 8 weeks course on financial modeling (similar to excel school). But that is almost 50% complete right now. If you want to join, you can join the next batch (probably starting in Jan/ Feb)
Feel free to get back, if you have any queries regarding the model/ steps in creating the same
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I want to learn how to build a financial model
Dear Lulama,
You can use this tutorial to learn to build a financial model. We also run a course on financial modeling and project finance modeling. The details can be obtained from:
http://chandoo.org/wp/financial-modeling/
You can consider joining that as well.
I would strongly encourage you to join the newsletter to get the updates about financial modeling and the next batch starting for the course.
I want to learn thorough excel and financial modelling thing !!! I am a chartered accountant..CAn you please suggest a detail syllabus that should be learn by me. Also suggest any classes that would cover everything in excel and financial modelling related things.. I stay in mumbai, so please suggest a class in mumbai or any books..byyee.. thanks ..
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Hi Vivek,
We do conduct the financial modeling course online as well as in Mumbai. We start with the basics of excel and build a completely integrated financial model in the class. For details you can look at:
http://chandoo.org/wp/financial-modeling/
or
http://www.edupristine.com/courses/financial-modeling/prisitne-fm-offering
Please describe to me various type of financial modela and demonstrate how a model can be build.
Regards,
Dear Immanuel,
This series of articles does exactly that. If you go step by step through the articles and create the excel sheets on your own, you will understand how to create an integrated financial model.
Alternatively, if you are looking for video sessions, you can consider joining our course:
http://chandoo.org/wp/financial-modeling/
It is expected to reopen somewhere in mid july.
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Paramdeep Hi! A bit ignorant here, but let's ask anyway. Can I access "recorded" video sessions apart from following the step by step articles?
Thanks!
@Marius: Yes, we do have a training program with recorded video sessions. If you are interested, you can enroll for the same. The details can be obtained from: http://chandoo.org/wp/financial-modeling/
i want to know about the scope of financial modeling.i also want to know after doing financial modeling course what are the job prospect, like where i can found job so plz send me full detail of financial modeling from beginning levelo to final.
I am interested to join your Financial modelling class cos am involved in a new business. But I have a Macbook Air with Excel for Mac installed. Would that work with your program?
Dear Charsiew,
The complete training program is built using Excel 2007 with MS windows. Though there is nothing specific to Microsoft in the training. I think a few people have joined the program and are using MAC. If you write an email to me on paramdeep @ gmail.com, I can send you the email ids of those participants and you can get to know their feedback and difficulties in using the program.
This is great, when does the next batch start?
Dear Karan,
The course is in recorded format and you can register for the same as soon as you want.
Paramdeep, thanks. I'm venturing into financial modelling for the first time and from the little I've read from your website already, I'm sure I'll find your resources very useful; thanks once again.
Dear Seun,
I am glad that you are finding the resources to be useful. Feel free to send in comments with your feedback and further questions.
hie ppl...I jst wantd a small favour cn smone help me out in calculating EBITDA, along with its working, from wipros annual report 2011-2012, link - http://www.wipro.com/investors/annual-reports.aspx
...PLZ plz... i am having a submission tommorow.
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Nice article.
In designing Excel Financial Models I design the user interface as friendly as possible and structuring the input variables in the workflow of the client's operations so that they can flow through the impact of the input variables in Excel using buttons and macros and giving the model transparency.
Cheers
Arthur
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Another step to build any financial model is to do a financial analysis beforehand. This normally helps to design and come up with good projections.
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