Securing your stars: Responsible use of financial models

In ancient times, powerful men and women looked to stars to help them decide on the state of their affairs. The cosmos was widely believed to contain information on what the future holds. Today, decision-makers no longer gaze at constellations when weighing their options. In business, seemingly charmed tools called financial models are viewed as necessary instruments in evaluating prospective investments or strategies.

However, like astrological speculations, financial models are not always accurate in their predictions. As uncertainties permeate the rising number of financial transactions, investment bankers, top-level executives, and various stakeholders are constantly navigating an environment where marginal errors in judgment can either make or break a company. Absolute reliance on financial models exposes users to the risk of suffering financial losses and other similar adverse consequences due to flaws in model assumptions and structure, and misinterpretation of intended use. While models are really helpful tools, it is important to closely examine their key assumptions and features, before using them to seal your company’s fate.

Perceive before you believe

As they are built to capture the position of the company in the future, financial models are heavily dependent on financial, operational and economic assumptions and projections. As such, the choice of assumptions, such as revenue growth rates and cost bases, should be carefully probed.

Assumptions should be reasonable and justifiable in such a way that they are able to exhibit the realities of the company and the environment where it operates. Thus, information on what the company has done in the past, what it is currently doing, and where it is headed should all be considered. In addition to company information, the market trends and forecasts should also be closely examined. Are they behaving similarly to the company’s projections? Are there forecasted fluctuations that may impact the company? If so, how will these affect the assumptions in the model?

Recognize that the market is unpredictable, and so are the assumptions grounded on it. Therefore, you have to constantly benchmark the numbers in a model with the company’s track record, the industry where it operates, and the country it operates in. If deviations are noted, reconsider the assumptions—if needed, even the structure itself—and check for consonance with realistic scenarios.

Scrutinize, then initialize

In addition to checking the primary assumptions, it is also important to examine the structure of the model, particularly its level of complexity. Generally, the more complicated the model, the more prone it is to spreadsheet errors related to formulas and linking. A simple mistake in entering a formula in a single cell could have an exponential effect on the entire model structure which, ultimately, could adversely impact its integrity.

Moreover, you have to test the model for extreme simulations involving worst case scenarios. This will show how sensitive your model is relative to changes in key assumptions that drive it. If your model turns out to be unresponsive to sensitivities, further revisions may need to be made.

The structure of the model is the skeleton that binds all the assumptions together to show various scenarios to which decisions will be anchored. Hence, it is important to scrutinize its structure to better understand the model’s purpose and how to best use it.

Be conscious of purpose

In his article “Financial tools must be handled with care”, Professor Salvatore Cantale of International Institute of Management Development Business School underscored that, “not all models can be used in all situations.” In other words, you should first analyze the reason why the financial model was built before using it to place your bets.

Each model is tailored to serve a specific decision making problem. Some models, for example, are structured to determine the additional leveraging required for a particular project. Framing your decision on this model when what you need is to determine the allowable increase in variable costs to hit break-even will be very risky since it is not built for break-even analysis scenarios.

Most often, no matter how dependable your model is, its relevance suffers if it is used for a purpose other than what it is intended for.

Navigation, not prediction

When deciding on the future, the ancients would probably advise today’s decision-makers to watch out for “the fault in their stars.” Since financial transactions are constantly tangled with complexities and uncertainties, prudence and due diligence should be exercised when basing decisions on financial models. Know that they have limitations and understand that they are merely indicative of the company’s projected position.

Nowadays, stars are no longer trusted for their predictive powers, but they continue to be reliable tools in navigation. Similarly, although financial models cannot guarantee future conditions, they can certainly point you in the right direction provided you understand them and use them wisely.

Renante Bere CPA is a Lead Consultant with the Advisory Services Division of Punongbayan & Araullo.

Executive Brief – October 2012

Punongbayan and Araullo

Online shopping: What could make Filipinos buy?

It’s the run-up to the holiday season. The time for Christmas parties, exchange gifts, and family reunions is almost at hand. Among majority of Filipinos, the most joyous part of the year has always been the Christmas season. However, chances are the Christmas season may also be the most stressful holiday period. Typical culprits can include the heavier-than-regular vehicular traffic, crowds and chaos in shops (in malls and more so in discount centers), and the seemingly non-ending (and confusing) choices for those gifts for family, loved ones, friends and colleagues. Under these settings, online shopping can be an attractive alternative.

The Philippines is relatively late in online shopping even among its Asian neighbors. This may be a function of the country’s low internet penetration rate (the share of internet users to total population), which was at 33% as of December 2011 (source: Internet World Stats). This is much lower than the rate in the Philippines’ more developed neighbors but is at par with the country’s relative economic equals.

ASEAN penetration rate
		Internet users	Penetration rate
Country	Period	(miilions)	(%)
Singapore	Jun-10	3.7	77.2
Brunei	Jun-10	0.3	70
Malaysia	Dec-11	17.7	61.7
Vietnam	Jun-12	31	33.9
Philippines	Dec-11	33.6	33
Thailand	Dec-11	18.3	27.4
Indonesia	Dec-11	55	22.1
Laos	Dec-11	0.5	8.1
Cambodia	Sep-12	0.7	4.4
Myanmar	Jun-10	0.1	0.2

Source: Internet World Stats

However, despite just being in the middle of the pack in terms of internet penetration, the Philippines is among the top countries worldwide in terms of social media network usage. The Philippines ranks 8th in the world in number of Facebook users (source: Socialbakers) and 10th in Twitter users (source: Semiocast). The interesting question then is: does the relatively large number of social network users in the Philippines translate to a large online shopping market?

Based purely on the size of the social networking population, the potential online shopping market in the country is huge. Unfortunately, there is a dearth of statistics to conclude if social network users indeed generate actual online shopping in the Philippine setting. There are some indications, however, that online shopping is gaining popularity.

Sulit.com, which used to be the dominant online buy-and-sell site, is now facing stiff competition from AyosDito.com. There is already an eBay site for the Philippines as well. Online shops such as lazada.com, zalora.com, and Kimstore.multiply.com are now quite popular. Group buying sites, such as Ensogo, dealSPOT and Deal Grocer, have also gained traction over the last couple of years.

Be that as it may, the volume and growth of online shopping do not just depend on the size of the market. On the assumption that all technical requirements are properly in place, the characteristics of such a market may prove to be even more important than its size. Just as with any business venture, an understanding of the characteristics of such target market may eventually define the success of Philippine online merchants.

While Filipino buyers may consider the same thing as other buyers — e.g., finding the right balance between price and quality, looking for a good deal — there are some peculiarities that need to be acknowledged (and addressed) by online merchants. Some of these peculiarities and their possible implications include the following:

1. Filipinos have the “suki” (or favorite) mentality. It is not uncommon for Filipinos to search and find an item they like from a shop or site, and then go to their suki merchant to purchase the said item. Aside from possibly getting a good deal, Filipino consumers trust their suki to sell only quality items. Online merchants would thus do well to obtain and present all the necessary certifications and testimonials about their service. Word of mouth endorsement is also very powerful for Filipinos.

2. Filipinos also have a “tingi” mentality, typically buying regular goods in micro packages. This is mainly due to the perceived affordability of smaller sizes. For online merchants to succeed, the products and services they offer must be (or at least perceived to be) affordable. The increased popularity of group buying sites may be due to the perceived affordability of its offerings.

3. Physically touching (and sometimes even smelling) merchandise is important to a lot of Filipino shoppers. To give potential online shoppers a chance to do this, online merchants may consider establishing a small physical store or even a kiosk.

Would addressing these characteristics ensure success? Not necessarily. However, adding in the Filipino tradition of warmth and excellent customer service, the probability of being an online hit should be further enhanced.

By Raul S. Tomas CIA is a Managing Consultant with the Advisory Services Division of Punongbayan & Araullo.

Executive Brief – November 2012

Punongbayan and Araullo

Mass participation in risk management

The typical mental picture of an enterprise risk management (ERM) activity is usually that of an austere-looking group of men and women in suits, huddled together in a board room, intently discussing the strategies and policies that have to be implemented to address their grocery list of risks. While ERM is initiated by the board, risk management is not an isolated process that is managed through padded conference halls. In fact, risk management is a dynamic activity that affects all levels in an organization.

According to the Committee on Sponsoring Organizations (COSO),

“ERM is a process, effected by an entity’s board of directors, management and personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of the entity’s objectives.”

From COSO’s definition, ERM is an activity that spans an enterprise and involves the 360-degree participation of personnel. Risk, after all, is the responsibility of everyone within an organization. If this mindset is not properly communicated, front-liners in business units may limit their participation to simply followingthe risk policies set by the board as implemented by the C-suite executives when they could be doing more: Apart from following risk policies, business units are also tasked with identifying and reporting all risk exposures to the Chief Risk Officer (CRO) and Chief Executive Officer (CEO), and assuring that risk information is reported to the CRO and CEO.

While people at the operational level may not have first-hand participation in setting risk policies, it is in this area where risks are managed on a day-to-day basis. Business unit personnel comprise the majority of an organization’s population and are oftentimes the first people to spot potential and actual risk exposures. Though the business units’ task checklist in ERM is not as comprehensive as management’s, your organization may be missing out on the “wisdom of the crowd” if you do not provide a platform for the majority of the people in the organization to participate in risk management.

Your “crowd” does not have to take part in all of the ERM processes, but venues should be made available so that their suggestions and identified risks and solutions, can be heard and evaluated for merit. The following are some technology-based channels that your organization can use to harness the power of mass participation in risk management:

Internal risk knowledge database

Leverage on your existing IT infrastructure to create a risk management database that can be accessed by or made available to employees. Submissions for new entries in your risk database can be managed or gathered at the front-end by providing a landing page on your existing intranet website for enrolling new risks/risk solutions. New risk submissions may be evaluated by your risk management unit under the CRO using set criteria — e.g., frequency of the same risk incident being reported, organizational levels where the risk has been reported, potential impact, if they are for assimilation in your existing risk matrix. Risk solutions may also be gathered through the same landing page.

Collaborative communication tools

If you have existing collaboration tools such as Microsoft SharePoint or other wiki tools, you may consider customizing them to allow for collaborative work in gathering data for risk identification and mitigation. Defining who to provide access to, as well as the specific activities that can be performed through collaboration, has to be defined at the onset to ensure that the information gathered can be properly evaluated and considered for integration or implementation in risk management processes.

Social media

Facebook, Twitter, and other social networking sites may provide you with another venue for opening up your risk management activity to a broader audience. It may be challenging to gather meaningful inputs from these sources, but if objectives and methods on using these sites are properly defined, social media can be an effective tool in facilitating discussions and harnessing rich inputs from employees to identify and address risks. Discussion boards, polls, quick surveys, and other data gathering techniques may also be deployed using social media.

The above listing is not exhaustive as there are other means by which you can engage employees in the risk management activity. As with any strategic decision, benefits and costs have to be weighed before technology-based channels for ERM can be implemented in your organization. Traditional methods such as defined escalation policies, face to face consultations, integrated risk reporting in process workflows, are other mechanisms for employee participation. Regardless of the tools or methods, a culture of encouraging dialogue and providing employees with open channels for discussing risks are essential for ERM to succeed in your organization.

Jahleel-AN A. Burao CPA is a Lead Consultant with the Advisory Services Division of Punongbayan & Araullo.

Executive Brief – November 2012

Punongbayan and Araullo