Financial Modelling
Foretelling the future – Modelling is the answer
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. GoalFix’s
Colin Human gives an overview of financial modelling, which will allay that fear.
F
or 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?
Financial modelling may be defined as the
task of building an abstract representation (a
model) of a financial decision-making situation.
Typically, this is a mathematical model
designed to represent the performance of a
business, a project, an investment or, even,
proposed strategic initiatives.
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
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Directorship
Jul - Aug - Sep 2012
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.
Applications include:
■ 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.
Requirements of Modelling
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 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
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.
Model Anatomy
Schematic
Specification
IS Schedules
Inc. Statement
Input Drivers
Statement
Cash Flow
BS Schedules
SsSchedukles
Sensitivity Analysis
Executive Summary
Balance sheet
Model Outputs
Typical outputs from financial models
include:a. An executive summary, incorporating
all key results, ratios, sensitivity
analysis, alternative scenarios and
supporting graphs.
b. A comprehensive set of financial
statements including an Income
Statement, Balance Sheet, Cash Flow
and all relevant supporting schedules.
Scenarios & Data Tables
•
•
•
•
•
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.
Modelling Benefits
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:a. ‘What if’ analytical capability
b. Multiple scenario evaluations
c. Instant identification of key drivers –
sensitivity analysis
d. Identification and evaluation of risk
e. Answers to questions such as:-
Ratios & Returns
•
•
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)?
Conclusion
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.
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. The questions that
executive management should be asking
are:
• Can we really optimise business
performance
without
utilising
modelling capability?
• Could this highly effective tool add
a powerful new dimension to the
existing financial management and
planning process?
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