Transcript of a presentation provided by Adrian Miric to the Leaderex conference
Before we go into developing a financial modelling strategy that supports business goals I want to address some Financial Modelling misconceptions.
- IS NOT detailed debt, NPV and IRR calculations
- IS NOT Monte Carlo Analysis
- IS NOT The next step after Advanced Excel
- IS NOT Only for the top of organisations
- IS Any calculation that is forward looking (hence our course is called Financial Modelling, Forecasting and Budgeting)
- IS Important for everyone in the organisation down to almost the lowest level
- Should rather be called Decision Modelling as it is not always financial
- Can be used for any Business Goal
As a result I will refer to the strategy as rather applying to Decision Modelling but it is interchangeable with financial modelling.
Developing a financial modelling strategy that supports business goals
We will look at the following areas
- Why a financial/ decision modelling strategy matters
- Who should the strategy incorporate
- What are some of the areas it should cover
Why a Financial/ Decision modelling strategy matters
Below some research results showing the prevalence or errors in spreadsheets, which are the main tool used in the modelling process.
Although some of these are a bit old now, various groups looked at a selection of spreadsheets and tried to identify errors, sometimes based on their particular focus (tax errors, >5% errors etc).
You will note that the percentage with errors is never zero percent. Our experience with Financial Model reviews bares this out. We have never performed a review where we found no errors. In fact if we don’t have at least 50 queries, we tend to go and find what we have missed.
In the ideal world, a spreadsheet model is carefully planned, built with lots of time and there are no last minute changes. In reality, there are time pressures, last minute changes and new requirements that appear and these pressures cause the errors.
But so what, no one has lost money due to these errors! See below
Financial Model errors cost real money
EUSPRIG maintains a list of known errors in financial models and spreadsheets where the impact is shown. Some examples include
- US$ 26 million hedging error- budgeted for more than needed
- South African example- Eskom and the Optimum fine- spreadsheet error reduced fine by R1.5 bn
- M&S financial reporting error
- Rounding of numbers on budget- underestimate of $36 million
- Inserting/ deleting rows or columns- underbid of project amounting to $250 000
- Incorrect sign on accounts- $2.3 billion information distortion
- Your own examples here
Note that these don’t all appear to be the ‘typical’ financial models. Some seem to be budgets, others are valuation models, some are simple management reports with some forward looking numbers.
So the above explains why you MUST implement a financial/ decision modelling strategy. Errors occur all the time and they do cost real money.
Who should the Financial/ Decision Modelling strategy address
Upfront I will tell you I am biased. We believe the whole organisation should be considered in any strategy.
Instead of just listing every department in a business, below some case studies of recent consulting engagements to understand who in an organisation uses financial/ decision model thinking.
Typical Financial Models and Financial Model Reviews
In the past year or so we have been involved in the following financial model builds and reviews. Note that in all these cases, the client knew they wanted a financial model and asked for it.
- Fish farm
- Greenfield property development (South Africa, Rwanda and Baghdad)
- Mine feasibility models
- Rental property investments
Note all these assignments were characterized by the typical financial modelling requirements i.e.
- 10 plus years of forecasts
- Detailed operational modelling- taking into account life cycles of fish, sales profiles and repayment methods of various countries property developments and key mining metrics)
- Detailed debt, NPV and IRR Calculations
- Sensitivity analysis
- Requested by the FD/ CFO/ New Business department- generally the top levels within an organisation.
If this was the only thing to cover in the financial modelling strategy, then it is very simple.
There are only a few people involved so just focus on them.
But we discovered that the techniques used to solve these problems, were also being used on assignments that would never have initially been called financial modelling. When the client contacted us they didn’t know they were asking for a financial model, but that was the reality. Some examples below
Not so typical Financial Models
- Actual, Budget and Forecast Reporting Tools
Management reports that can (quickly) update for the latest actual results, and at the same time compare to budget/ forecast, but more importantly look at the remaining period and indicate what the company is likely to end up on.
- Quoting Tools in manufacturing with direct and indirect costs
A quoting tool for large scale manufacturing that takes direct costs into account (simple financial model stuff) but also takes into account the Indirect costs.
- Contract Management Reports in Biotech
In the one case the legal department needed to track performance against a contract. The historic information needed to be included, but more important was an updating forecast to assess what needs to be done over the remaining period to meet the contract obligations and how feasible it is to do this.
- Machine Maintenance forecasting- when will a part fail
In these cases it is NOT a financial model. All the clients wanted to know was, given the machine parts historical lives, when will each part likely fail given some forecast production. No mention was made of financial modelling, but the techniques used in financial modelling was the only way to provide the solution. Note that there was also no financial impact included.
- HR BEE Scorecard
HR needed to keep track of their head count statistics, but also assess the possible impact on these statistics taking into account future retirements and other movements in order to meet BEE targets.
Note that the above assignments are all characterized by
- Some historic information and then forward looking
- Short term- next job, next year, next few months
- No debt, NPV or IRR aspects
- Sometimes does not even cover financial information
- Requested by FD’s, Sales team, Legal Departments, Engineers and HR
IFRS and the Non Typical Financial Models
Recently we have also assisted in a number of IFRS calculations. In all cases IFRS calculations are financial models. In the one case the financial model was very small (20 rows) but needed to be repeated 400 000 times for the underlying assets.
The clients did not ask for an IFRS financial model. They asked for help with the calculations and as it turned out, these were just financial models repeated again and again.
These assignments were characterised by:
- Forecasting forward and then bringing back to today’s numbers
- Significant Time Value of Money Calculations
- Requested by FD but for the accountants.
So who should be considered as part of any strategy to address financial and decision modelling?
We believe that
- Most people in any organisation should be aware of it
- But the level of knowledge will differ
NPV, IRR, Monte Carlo simulation are just one minor part of decision modelling. Very few people need to know this level of detail. But there are tons more decision models that are being built that would benefit from understanding financial/ decision modelling.
What should be covered in the Strategy
- Difficult to pin down as the strategy needs to potentially cover so many areas
- It is a people issue, there is no magic bullet piece of software
- All people within the organisation should have access to
- Best practice guidelines – freely available
- They are common sense and not complex
- Our online financial modelling course has a free section which covers the best practice techniques
- Best practice guidelines – freely available
- Incorporate the thought process into training, typically in Excel training but a standalone half day course on the topic is also useful.
- The strategy needs to create consistency across the organization
- Emphasis on getting the ‘engine’ right- NPV, IRR’s are easy to calculate when the operational numbers work. Too much emphasis is placed on this financing jargon and not enough on the engine of any model which are the operations.
- Importance of decision being made must affect approach
- Consider minimum expected outputs
- Share concepts not prescriptive on method
- Flexible to address the different users of decision models
Some items to include in the Strategy
- Importance Questionnaire
- SOX in the USA has helped with some of these
- Insist that all stakeholders are considered (or at least listed)
- Must contain all financial statements for a financial model
- NO Balancing number on the BS. It MUST self calculate.
- Some form of check for other models (mass balance for engineers?)
- Insist on Testing- lack of testing of decision models is the biggest issue
If you want to be a bit more prescriptive consider including some of these:
- Time periods should be monthly or less, never annual. We can show you an Excel trick that converts monthly into annual in 5 minutes, but the other way is much harder.
- Must have error check sheet built in
Whatever you end up including, keep in mind that you are trying to create a common approach to forward looking calculations (not just financial models).
It is also important to note that Decision Modelling is NOT an advanced skill. Any Intermediate Excel user can (and does) do decision modelling. How well they do it depends on the knowledge you provide.
Financial Modelling Strategy Conclusion
- Financial Modelling is about more than the ‘typical’ financial models (should be called Decision Modelling)
- It is a people issue, best addressed by training and knowledge sharing
- Your strategy MUST include every department in the organization as they are all making decisions continuously
20% Coupon for online Financial Modelling Course
If you attended the live presentation you will have the coupon to receive the 20% discount on the online financial modelling, budgeting and forecasting course
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