This was a pertinent question posed in one of our recent Financial Modelling Masterclass training courses.
The simple answer is you can’t. You can’t model what you don’t know about or what’s not on your radar screen.
But a robust, agile Financial Model can help you charter the smartest route through chaos while future-proofing your business for resilience and returns.
With black swans increasing in frequency, size and scale, Financial Modelling is proving to be one of the most in-demand skills to create a competitive advantage for financial professionals and organizations alike.
What are black swans?
Originally coined by mathematician and stock trader, Nicholas Nassim Taleb in 2007, black swan events have three primary characteristics:
1. They’re unpredictable
2. Have a huge impact on society
3. Are often viewed in hindsight, as something we ought to have predicted.
As such, pandemics always retain the potential to become black swans.
The Corona Pandemic, a perfect case in point.
In the last two weeks alone, the Dow Jones, along with nearly all other global indices, have gyrated furiously, with circuit breaker mechanisms not seen since 1997, coming into effect an unprecedented three times. With worries of a recession taking shape on Wall Street at the start of the year, an analysis conducted by Goldman Sachs economists seemed to mute these fears,
calling the US economy “structurally less recession-prone today.”
Amid the US-China trade war, geopolitical uncertainty around Brexit, and a sluggish global economy, the report represented a sea change from the general current within investment circles. There was an admission that the 11-year bull run that the markets had embarked upon would end, but that they would do so gently.
Just 11 weeks on from the Goldman Sachs prediction, the world is now staring down the barrel of a pandemic that appears to have no end in sight. Countries across the globe are in lockdown, industries and businesses in shutdown with millions of livelihoods on the line.
For all the progress that has been made in perfecting economic and financial modelling tools, the inability to account for a variable capable of such catastrophic effects, is what makes the coronavirus pandemic a classic black swan event.
Chartering a sustainable way forward
With the current global and health crisis heralding in a tsunami of chaos, change and uncertainty, properly constructed financial models based on comprehensive and detailed analysis of the specific business structure, afford corporate executives the ability to explore alternative scenarios and conduct what-if analysis on all key business drivers.
Thanks to financial modelling techniques, the statement “if it can’t be measured, it can’t be managed”, need never apply to proposed business initiatives, irrespective of their nature.
Putting it into practise
Stemming from the basic premise that the primary responsibility for all corporate executives is to maximise shareholder value, and given the complexity of modern business, financial modelling offers the following very real and tangible benefits:
- ‘What if’ analytical and predictable capabilities
- Multiple scenario evaluations
- Instant identification of key drivers – sensitivity analysis
- Identification and evaluation of risk
- Answers to questions such:
Which components of performance optimise the creation of shareholder value?
What are the key drivers of RONA / ROCE / ROE?
What annual compound growth rates are achievable, and what effect will these have on working capital, cash flows and RONA / ROE?
What is the internal sustainable growth rate based on current profitability, activity and cash flows?
What effect will gearing (leverage) have on shareholder returns (ROE)?
What is the dividend capability based on free cash flows?
Is the business performance adding value in relation to the WACC – Economic Value Added (EVA analysis)?
In conclusion
Clearly strategic planning and scenarios are a vital part of setting business objectives and goals, and properly constructed financial models are invaluable tools to quantify or measure the effects of such strategic plans.
Unquantified strategy, in truth, is little better than wishful thinking.
Historically whilst there may have been a modicum of scepticism about the art of modelling, the development of sustainable modelling processes and best practice methodology has long since laid any reservations to rest.
The questions executive management should be asking themselves are:
- Do we have the necessary tools to assist us to quantify the effects of the “corona” black swan event?
- Can we really optimise business performance without utilising modelling capability?
- Could this highly effective tool add a powerful new dimension to the existing financial management and planning process?
JC Human CA (SA)
Goalfix Financial Modellers
24 March 2020