Fear of the future, and if not fear, then concern or hesitation is a common and understandable human emotion, which confronts all of us from time to time, even seasoned business executives.
For centuries mankind has sought to predict or foretell the future, and modern business executives are no exception.
The plethora of predictive business analytical tools is testimony to this fact.
Whilst predicting the future may be a bridge too far, the proposition contained in this article is that through the application of modern financial modelling processes, executives can model or simulate the future of their organisations with remarkable accuracy.
Properly constructed financial models, based on comprehensive and detailed analysis of the specific business structure, afford corporate executives the ability to explore alternative scenarios and conduct what-if analysis on all key business drivers.
Successfully meeting the challenges of modern business, optimising shareholder value and managing for results, without using appropriate models, may indeed present management with an insurmountable challenge.
Thanks to financial modelling techniques, the statement (adage) “if it can’t be measured, it can’t be managed”, need never apply to proposed business initiatives, irrespective of their nature.
Financial Modelling defined.
What is financial modelling?
We at Goalfix define financial modelling as:
“the assembly of all relevant components of a business case, in a logical and structured manner, into a predictive tool for the evaluation of financial performance.”
Clearly to be effective, financial models must be properly researched, properly built, flexible and fit for purpose.
Financial modelling is a general term that means different things to different users; for our purposes the reference usually relates to corporate performance and corporate financial applications.
The financial modelling process has gained universal acceptance and rigor over the years, and in some cases, is an essential requirement for financing capital projects.
Corporate Financial Modelling
In corporate finance, investment banking and the accounting profession, financial modelling is synonymous with cash flow forecasting.
This usually involves the preparation of large, detailed company specific models used for decision making purposes.
These models are almost always discrete in time and are usually deterministic in nature (based on input assumptions).
They are ideally suited to what-if analysis and determining the sensitivity of input assumptions.
- Evaluation of strategic initiatives
- Scenario planning and management decision making ("what is"; "what if"; "what has to be done")
- Mergers and acquisitions
- Budgeting and budget evaluations
- Capital budgeting
- Cost of capital (i.e. WACC) calculations
- Management reporting
- 1, 2, 5-year forecasts
- Rolling forecasts
- Business optimisation involving financial analysis and / or financial statement analysis
- Project finance
- Business valuation, especially discounted cash flow, but including other valuation techniques
Some Modelling Observations
Modelling practitioners are sometimes referred to (tongue in cheek) as "number crunchers”.
However, in reality, modelling requires insight, planning and analysis (see diagram) and by its very nature, demands the identification and quantification of the fundamental business drivers – the same drivers which derive from the determined business case or strategy.
As such, it is the distillation of all the key elements of a business case, in a logical and structured manner, and the creation of a flexible dynamic predictive tool for business improvement.
Patently to avoid model outputs which incorporate unrealistic assumptions and structural inconsistencies, it is critical that the business dynamics are fully researched. (for example, a forecast for growth in revenue but without corresponding increases in working capital, fixed assets and the associated financing, may imbed unrealistic assumptions about asset
turnover, leverage and / or equity financing).
What is required is that all key drivers of the business structure or strategy are carefully identified, and their relationships are explicitly and consistently forecasted.
At all times a reality check based on the business model must be applied to crucial assumptions, and where appropriate, probability distributions and statistical measures such as regression analysis and Monte Carlo simulations may be required.
Typically, financial modellers will have a completed an MBA or CA with (optional) coursework in financial modelling, but the process is in no way limited to persons with a background in finance.
The knowledge necessary for successful model building may be summarised as follows:
a. Knowledge of essential spreadsheet functions and techniques required to build comprehensive models,
b. Knowledge of accounting conventions and the composition of financial statements
c. Knowledge of corporate financial principles and terminology, performance measurement, measurement of returns, Present Values, Internal Rates of Return, and net and free cash
d. Knowledge of best practice financial modelling methodology
Typical outputs from financial models include:-
- An executive summary, incorporating all key results, ratios, sensitivity analysis, alternative scenarios and supporting graphs.
- A comprehensive set of financial statements including an Income statement, Balance sheet, Cash Flow and all relevant supporting schedules.
Stemming from the basic premise that the primary responsibility for all corporate executives is to maximise shareholder value, and given the complexity of modern business, financial modelling offers the following very real and tangible benefits:-
- “What if” analytical capability
- Multiple scenario evaluations
- Instant identification of key drivers – sensitivity analysis
- Identification and evaluation of risk
- Answers to questions such as:
- which components of performance optimise the creation of shareholder value?
- what are the key drivers of RONA / ROCE / ROE?
- what annual compound growth rates are achievable, and what effect will these have on working capital, cash flows and RONA / ROE?
- what is the internal sustainable growth rate based on current profitability, activity and cash flows?
- what effect will gearing (leverage) have on shareholder returns (ROE)?
- what is the dividend capability based on free cash flows?
- is the business performance adding value in relation to the WACC – Economic Value Added (EVA analysis)?
Clearly strategic planning and scenarios are a vital part of setting business objectives and goals, and properly constructed financial models are invaluable tools to quantify or measure the effects of such strategic plans. Unquantified strategy, in truth, is little better than wishful thinking.
Historically whilst there may have been a modicum of scepticism about the art of modelling, the development of sustainable modelling process and best practice methodology has long since laid any reservations to rest.