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