What is an Excel model?

You’ve probably heard the term “Excel model” thrown around quite a bit on the job. Excel users love to talk about the models that they’ve created, and how they’ve helped produce important analytical insights. But the truth is, the word ‘model’ means different things to different people. For one analyst, it might mean a simple set of calculations within Excel. And for another, it might mean a complex spreadsheet that predicts financials over time driven by dynamic inputs.

For our purposes, we’ll define a model as an Excel spreadsheet that makes quantitative estimates or predictions based on a set of underlying assumptions. Generally, models are used to determine some outcome based on a number of different potential scenarios. They’re useful because they can help decision makers get a sense for how changes in assumptions will impact results.

Most frequently, models are used to predict a company’s future profitability based on assumed revenue and cost growth rates. However, they also have a ton of other potential uses: for example, estimating an individual’s retirement savings by taking into account current salary, tax rates, IRA contributions, and estimated changes in income over time.

So why is it important?

So, we've defined what an Excel model is:

An Excel model is a spreadsheet that makes quantitative estimates or predictions based on a set of underlying assumptions.

But why exactly are Excel models so important, and how can they possibly be so common in the business world?

Here's the answer:

Businesses often succeed and fail based on the accuracy of their predictions about the future. A cookie maker, for example, needs accurate estimates of how many cookies it will sell in the future in order to determine how much of each ingredient — like butter, sugar, and flour — it should buy. A software company considering acquiring a competitor needs to know how much money it should expect that competitor to make each year in order to determine an accurate valuation. And a furniture company needs to reasonably predict its future cash flow in order to determine how much money it can spend on advertising this year.

In each of these cases, accurate estimates of future performance are critical for the success of the business. If the cookie company overestimates the amount of each ingredient needed, it will waste money on food that spoils. If the software company overestimates the future profits of its competitor, it will end up paying too much for it and losing money. And if the furniture company overestimates its future cash flow, it may spend too much on advertising and not have enough to spend on buying raw materials for its products.

Modeling is a way to make more accurate predictions about the future by breaking down a problem into its individual pieces. In this course, for example, we'll be following SnackWorld as it estimates its profitability 5 years into the future. Rather than throwing out a random guess of how much profitability will grow, SnackWorld can come to a more accurate estimate by breaking down profit into its individual components — Revenue and Costs. By estimating the growth rates of those components at an individual level, SnackWorld hopes to increase the accuracy of its predictions about profitability — and, in the process, be able to make better decisions today about its business.

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