You need to know the rules in order to break them successfully

Financial Modelling

One of the most advanced financial skills is building a financial model.  It’s advanced not because it is technically difficult but because it simplifies.  It codifies complex situations, puts boundaries on the key variables and links these in a framework within which outcomes of different decisions can be considered.  In this it is very different from techniques such as discounted cash flow which are typically used to build a case for something you’ve already decided to do.  The financial model is a technique that helps you decide what you want to do in the first place.  It is part of the strategic decision-making process.

Necessary Skill

Financial modelling is a ‘gateway’ skill in a financial career: passing through it allows access to more senior positions; failing will limit your career potential.  It is particularly important that chartered accountants develop their skills in this technique quickly if they want to pursue a career in industry as auditing limits their exposure to decision-support techniques of all kinds.  Unfortunately it is not a technique that can be just ‘learned’.  It requires some strategic skill in being able to ‘see the big picture’ for it to be applied effectively.  Nevertheless, like strategic skills, whatever your natural ability, it can still be developed further with practice.

What is a Financial Model?

At a practical level, a financial model is just an accountant tinkering around with his or her spreadsheets: nothing more than a set of assumptions, some data and formulae.  I recall building a simple model to help colleagues with company cars decide whether they would be better off keeping the company car or taking a car allowance on top of their salary and running their own car privately.  The model was a single spreadsheet that codified the company’s company car rules, the tax regime at that time, made some assumptions about fuel costs, and invited people to plug in their annual mileage.  I landed myself in hot water, not because of any failings of the model but because I didn’t understand how attached everyone was to their company cars, interpreting my model as a covert attack on their employment rights.  This example illustrates the point about having some strategic skills!

The term model is not one I recall hearing in any finance class, but it popped up a lot in economics class and again when programming a computer simulation.  Bank of England forecasts combine both techniques when they describe a probability ‘fan’ of outcomes around their central forecast for inflation.  Models of how the earth’s climate works are behind all climate change predictions.  When biologists talk about models they might be referring to a mouse as a model for studying a particular disease.  All these models are, in varying level of detail, a proxy for studying the real world or, in the biologists case, human disease.  A financial model is just a proxy for a company, a market territory, or acquisition target: any business situation.  If you have a model of how the business works, you can play with some of the variables and explore the consequences.

It can be as sophisticated as you like.  Professional stock market analysts will have quite sophisticated models of the companies they follow, but a reasonably competent private investor could get two-thirds of the level of sophistication quite quickly, enough to reach similar decisions on whether to buy, hold or sell a stock.  In other words, there are diminishing returns from making your model ever more sophisticated.  Often, the direction of a decision can be reached without making a model too elaborate.  Equally, there is rarely the need to make the variables in your model so contingent and inter-related that you need employ simulation techniques to probe its mysteries.  Leave that for the economists and earth scientists.  In business decisions a deterministic model will be quite enough for most purposes.  You can simply change a few variables to prepare a sensitivity analysis to achieve a similar effect to the fan diagram of probable outcomes that the Bank of England use.

Building a Financial Model

My first experience in financial modelling was a young brand manager planning to launch a new product in an overseas market where we were already active.

We worked together to refine the ‘fixed parameters’.  This required gathering data from different sources around the company, some original investigations of our own, then benchmarking and reality-checking all assumptions. This information-gathering phase is common to all financial modelling.   Building the model is the easy part of the process.  Making sure the quality of the assumptions are robust is the hard part.  Once happy with the basic structure of the model, the brand manager was able to play around with the figures in blue (see table) which she could influence directly.

 

Like all brand managers, however, she was principally concerned to know how much marketing budget she could afford.  Once content that the product launch was viable, it was a fairly easy to amend the model to project forward several years, to calculate a discounted cash flow.

Using a Financial Model

This small-scale example was the launch of a shampoo in Saudi Arabia in 1992 (the numbers are illustrative).  A little later there was a much larger scale venture which perfectly illustrates the power and limitations of financial modelling.  The company – a corporate giant – planned a major launch of its global detergent brand in Saudi Arabia and the Gulf states, a territory where its arch-rival – another large corporate – had long had an almost unassailable 80% market share.  The company planned the launch as a ‘disruptive’ and aggressive attack.  The plan was to sustain quite a long launch period where we sold the product below cost price.  The financial model recognised that we would sustain very heavy losses but calculated that after 10 years, so valuable would be the market share gained that the investment would have proved worthwhile.  I think we were aiming to gain somewhere around 20-30%, from near zero.  I recall the excitement around our company at the time.  It really felt like we were going to shake things up.

Our rival reacted to our launch by matching our price reduction, but what they did next astonished us.  They started selling all their products in that territory at below cost price, and not just in the detergent category; not even restricting the price cut to all ‘home care’ products.  They slashed the prices of every single product, in every single category, in every country.  It was an ultra-aggressive response.  Their losses must have been horrendous, but it worked.  Our market share never got near our targets and, while we gained a foothold in the market, we gave up the aggressive tactics quite quickly.  (The strategy was led by an up and coming senior executive who later became Chairman after an even more aggressive product launch in detergents that also failed.  It just shows that failure need be no hindrance to career progression).

Financial modelling’s contribution to this story was, firstly, in telling us how long we would have to sustain losses and so we went into the launch with our eyes open.  Subsequently, the model also made it clear that failure to meet the market share targets meant the whole venture should be abandoned.  The fact that the launch failed, doesn’t matter.  It was a calculated risk, and the model helped us calculate that risk.   The real message from this story of course is that most strategies are developed with a very inward-looking bias, where opponents are assumed to behave much as they have always done.  This is precisely the point that game theory teaches us, but that’s a gateway skill for a higher level and another tutorial.

Words of Warning

I’m a great enthusiast for financial models but like all such techniques, they are just tools.  In practice, the important part of the work is in the strategic discussion with your colleagues around the key variables.  Whether your colleagues find your contribution valuable or not will typically depend on the quality of your input into these strategic discussions, not the quality of your spreadsheet formulas.

Here’s a cautionary tale to illustrate the point.  A colleague of mine was working with his finance director on an acquisition of a family owned business in Egypt.  The finance director was old school, the type that shouted a lot and made people terrified of him.  My colleague was a spreadsheet-wonk, a real computer geek.  He built a model for valuing this company that was a work of art in its complexity.  So the time came when my colleague and his finance director were sitting in Cairo opposite the owners of the business for the final negotiation meeting.  The finance director opens the meeting by saying his financial whizz-kid has been running the numbers and arrived at several insights as to why the asking price for this business was too high.  He then handed the meeting over to my colleague who switches on his laptop in preparation for taking these poor Egyptians through his computer model.  Only there’s a problem with the computer, or maybe the file was corrupted, but anyway nothing happens.  This chap lived in his computer so much he hadn’t brought print-outs and he’s not the sort of person who could carry the strategic discussion without referring to his spreadsheet.  Oh dear!  The rest of the meeting was given over to some good old fashioned haggling while my colleague sat in a corner of the room trying to get his computer to work.  Needless to say, the reason I know so much of what happened that day is that the finance director told everyone the story when he returned.  Not long afterwards, the chap took a job in Kuala Lumpur.

Summary

Financial models are a good way of framing a strategic debate.  Without them the debate would still carry on but in an unstructured way, with figures thrown around in e-mails, position papers and open conversation.  Decisions would still get made but there wouldn’t be the same clarity, which is one of the major things finance brings to the table in these situations.  We shouldn’t over-estimate their value, it’s the strategic debate that’s important, but in complex situations, they can reveal insights that otherwise are hidden.  Even in relatively straightforward situations, they can allow you and your colleagues to ‘play’ with different scenarios, thereby helping you crystallise your thoughts.  It’s one of the most commonly used advanced financial technique for decision making, and a vital skill for all finance people to develop.

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