Financial Modelling is basis of good decision making but right now it is more critical than ever. Find out why Financial Modelling is critical in the South African Environment

Background

Let’s just say that the South African business environment does have it challenges, some which are unique and some which are a consequence of the global economic order (or disorder).

With the COVID-19 pandemic being the largest global disruption for many decades, we are still experiencing its economic aftereffects with some supply chains still strained.

After a period of relatively low interest rates, continuous hikes over the past two years have increased the repro rate by 475 points, at this point, and have completely changed financing costs.

And then we have the escalation in the trade wars between the major economic powers causing economic uncertainty not to mention the effects of the war in Ukraine.

… and those are the consequences of situations where South Africa has little or no influence. Throw in the ever-increasing loadshedding, the break down in the provision of municipal services, endemic corruption, high levels of unemployment and crime and you wonder how companies continue to function in this environment.

Sure, a high level of resilience is required; however, in such turbulent times companies also need to have a clear comprehension of the potential consequences of their decisions. Almost daily we hear of companies, both large and small, who mis stepped and are quickly out of business. With the future focus of financial modelling, I am constantly perplexed as to why companies do not make more use of this tool to assisting in guiding them.

Financial Model Benefits

Built correctly, financial models should be flexible, able to adapt to changing inputs and predict the potential outcomes. However, probably the biggest benefit for a company is the ability of financial models to identify the key financial drivers of the business. Understanding these allows management to ignore the daily “noise” and focus their efforts where it will result in the greatest impact.

Distil all the assumptions and calculations and a financial model typically needs to forecast a company’s ability to generate cash – or predict when it will run out of cash!

Financial modelling can be applied to a company’s current operations, scenario planning, evaluating potential projects, business valuations including mergers and acquisitions, capital budgeting, strategy evaluation and many other aspects.

The construction of a sound financial model will facilitate sensitivity and what-if analysis and assist management in trying to navigate an uncertain future.

While financial models alluded to above relate primarily to accounting and corporate finance applications, they may also be used in asset and investment management applications such as

  • Option pricing
  • Credit derivatives
  • Credit scoring
  • Interest rate derivatives and more.

The Anatomy of a financial model

As a process that is required to model a future reality, the accuracy and efficacy of the financial model is dependent on

  • Having a clear understanding of the purpose of the model and
  • The information on which it is based.

It is therefore important that sufficient research and effort is committed to ensuring that the input data is accurate or reasonably acceptable. As important, is having a clear understand of the required outputs of the model. Once these requirements have been satisfied the financial modeller can set about determining the necessary construction of the financial model.

No matter how complicated the project may appear, the challenge for the financial modeller is to be able break the processes down into what are ultimately simple steps. Developing a model which has complicated formulas and is not well structured will comprise the veracity of the model. The intended users should be able to easily verify the outputs and also have an understanding as to how they were generated. The adage “if you cannot adequately explain the model to a child then you don’t understand it yourself” probably applies here!

This process determines that a financial model will ordinarily comprise an input sheet/s, working schedules and the output schedules. Users of the model may have the ability to change the inputs but should not have any ability to edit the working schedules or the output sheets.

As models are typically built to process different scenarios, the user should also have a clear understanding of what set of inputs are being used by the model.

While no universally accepted modelling standards currently exist, the model should be constructed according to generally accepted guidelines that will facilitate a general understanding and allow other modellers to easily adapt or update the model in the future.

Conclusion

With the apparent benefits that a properly constructed financial model can deliver, their use by South African companies must be an integral part of a company’s operational or decision-making process.

The use of a financial model obviously cannot guarantee success, but it should be an indispensable tool in navigating a company through the various challenges it will encounter. This implies frequent review and revision to comprehend the changing future outcomes so that corrective action may be taken as soon as is possible.

A model build by a certified financial modeller gives a company the confidence that the model will follow a logical, transparent process and give the management the necessary confidence in the outputs.