WEDNESDAY, 07 SEPTEMBER 2011 19:16 RAUL S. TOMAS / EXECUTIVE LOUNGE
HUMANITY’S fear of the unknown leads us to embrace science, which uses logical observation, reasoning and testing to explain observed phenomena. But for unknowns that cannot yet be seen or observed, we sometimes have no choice but to leave such uncertainties to prayer, chance or a fortune teller.
Businesses, however, cannot afford to do so. Business leaders need to know the what-ifs and their potential impact so they can develop alternative plans to minimize any negative effects or achieve set objectives.
In business, the measurement of most of the objectives and impact of variables is usually financial in nature. This is why financial modeling is becoming an increasingly crucial tool for C-suite executives. This “crystal ball” provides management with a vision of what the future may bring.
A financial model represents prospective financial information in the form of a financial forecast or projection, allowing management some measure of confidence to predict the future. A forecast uses best-estimate assumptions—that is, developments that management expects will take place—while a projection takes into consideration hypothetical assumptions about future events and management actions that may not necessarily materialize. Financial forecasts typically cover one to three years while financial projections cover four years and beyond.
The importance of financial models
Financial models help management assess the possible success (or failure) of their future plans, analyze the financial impact of changes in assumptions or variables, and get a glimpse of how business may operate in the future. These models are used by prospective creditors when considering whether or not to provide financing. Prospective investors also use forecasts and projections to evaluate the value of a business.
Consultants—typically professional accounting firms—are usually engaged to compile or examine financial models. They are also engaged to audit financial models and provide assurance regarding the integrity of the model’s mathematical structure and to guarantee that all stated assumptions are properly represented. This gives creditors more confidence to introduce various scenarios into the model and to analyze results. These consultants are also hired to examine the reasonableness of the assumptions used in the model. Such examination may include checking market trends and forecasts or reviewing actual contracts to assess the reasonableness of revenue and cost assumptions.
Do reasonable assumptions mean that forecasts or projections will be achieved? Unfortunately, no. It, however, provides users of financial forecasts or projections with a sense of assurance that the numbers are believable. Since, by their very nature, forecasts and projections involve events that have yet to happen, the actual result of planned operations is still subject to uncertainty. Because of inherent uncertainties in prospective financial information, sensitivity analyses (where critical assumptions are changed) and scenario analyses (where a set of conditions facing the company are revised) play a role in providing insight into how forecasts or projections change.
Financial models provide management with a view as to what the future may bring. But just as a fortune teller deciphers the messages from her crystal ball, how one interprets the vision may be more important than the vision itself.
(Raul S. Tomas is a managing consultant for the Advisory Services Division of Punongbayan & Araullo. For comments or questions, email Raul.Tomas@ph.gt.com.)
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