Financial Modeling Drives Optimal Decisions – January 2015

This topic involves financial management.

Financial modeling is an important tool that the CFO can use to help management make the optimal decisions in pursuit of the company’s goals. The tool accomplishes this goal by relating critical inputs to performance outcomes. This information is used to support planning and control efforts as well as evaluate strategic decisions.

Financial modeling facilitates analysis of risk and, thus, provides reasonable assurance that the firm will achieve its tactical and strategic goals of the project being evaluated. This is often accomplished by the utilization of a sensitivity (“what if”) analysis that mangers use to gain insight into possible outcomes. Evaluation of the projected outcomes of the project relative the model’s assumptions can then help management modify inputs as necessary.

Financial models are based on a set of assumptions and formulae that simulate relationships between the company’s operating and financing activities. We prefer developing financial models from scratch. This method has the advantage of increased usefulness due to customization and flexibility relative to off the shelf templates. We believe such templates can often be too generic and thus of limited usefulness for projects undertaken by specialized or niche oriented businesses. The key tradeoff is that for more complex strategies, such as entering new markets, developing a model from scratch can takes weeks rather than days.

The key elements for an effective and robust financial model are:

• Input. The data and assumptions must be examined carefully for validity and constructively challenged by the parties involved in the project.
• Simulation. The formulae and relationships inherent are precise and reflect a reasonable assessment of reality. Often easier said than done.
• Sensitivity Analysis. A pre-determined and straight forward process must be used to vary key inputs such as price, costs, volume to gauge how they affect profits and cash flow.
• Materiality. Focus on the validity of the underlying assumptions behind those inputs that have the greatest affect on results.
• Assessment. Evaluate the model’s output in light of the likelihood of the base, best, and worst case scenarios.
• Not overly complex. This helps avoid needless errors and “paralysis by analysis.”
• Decision Usefulness. Facilitates decision through analysis of costs and benefits.

Once the decision to move forward with the project is finalized, financial models should be used as a planning and operational control tool. To do this, management can marshal the appropriate personnel and assign responsibility. In addition, it can assess an important goals such as projected cash flow, which can be compared to actual results and corrective action implemented if needed.

Financial models can also be used to help develop strategy and tactics. One use is to compare operational metrics against industry benchmarks or best-in-class levels of performance. They can also be useful in identifying unfavorable trends such as slower payment times by customers.

Financial modeling allows management to be forward looking by embracing principles to analyze courses of action, assess the associated risks, and select the appropriate course of action. Accordingly, the effective use of financial models helps managers create and sustain value for the organization.

Capitol CFO Solutions serves clients in Washington D.C., Maryland and Virginia. Please contact us for a free consultation.