Category Archives: Financing

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Company Pulse financial planning

What is the correct assumption? Or how to choose a good set of baseline assumptions

In a meeting to review business case projections, the discussion ranged over various assumptions in the financial model and someone asked “But what is the correct assumption?” For those with a background in analysis, this question was an amusing distraction, but it raises an important point – what assumptions should you use in your business forecast?

One of the problems of any forecast is that it reflects the biases of the forecaster. And when you build a financial model of your business you are also making potentially biased structural assumptions about key business drivers. So, even though you’ve constructed a ‘rational’ financial model, it will inevitably be biased and the assumptions potentially unrealistic or inconsistent.

So what should you do to minimise bias? The best approach is to view all assumptions as just that, assumptions, and not facts, and to use sensitivity analysis to refine your understanding.

Sensitivity analysis helps answer the “what happens if…?”questions, such as sales X% down on forecast, payroll inflation up by Y%, or overheads reduced by Z%. A good financial model will have the capability to do this quickly and easily, perhaps with switches for key variables or scenarios.

The main benefits of sensitivity analysis are to evaluate the range of potential outcomes, to understand better the relationships between inputs (assumptions) and outputs; and to test the robustness of the model by revealing potential errors (as highlighted by unexpected, counter-intuitive or non-linear relationships between variables).

If you use sensitivity analysis systematically by adjusting your assumptions incrementally away from a central value, rerunning the model and reviewing the output, you can start to understand which variables are the most important to your business. A more sophisticated version is to use the Monte Carlo method to generate a large number of outputs having randomised each of the key input variables. Ideally you will automate this process and then run the model through a large number of iterations.

However accomplished, reviewing the range of outputs will give you a sense of the most likely outcome, and the potential range around that expected outcome. This process also provides a ‘sense check’ for your baseline assumptions.

There is another useful variant of sensitivity analysis to consider before finalising your baseline assumptions: break-even analysis, which allows you to find the levels for key variables where the model breaks even, for example sales volume, selling price or cost of sales (whilst holding all the other variables at their central assumption). Break-even analysis is a simple and powerful concept, but surprisingly under-used.

So, having reviewed your sensitivities and evaluated the break-even points, you have arrived at a better understanding of your assumptions. You may find that something previously considered insignificant is a critical, or the impact of some variables is reduced by self-correcting mechanisms, others may affect timings but not quanta, and yet others will be much less significant than the received wisdom would have suggested. You should also consider each assumption in the light of the others: are you assumptions mutually consistent? Such insights may provoke further research and debate as you home in on your baseline assumptions.

You will probably have realised by now that there is no such thing as a “correct assumption”. The best you can have is a baseline set of realistic assumptions that are internally consistent. What you do need is a management process: a progressive approach to a better understanding of your assumptions leading to a better forecast of the outcome.

This review process should continue every time you update the model with actual performance. After an update that results in a step change from the original plan, ask yourself “Is this the start of a trend, a blip, or a timing issue?” Keep running sensitivities (especially those suggested by recent actual performance) and, if necessary, update your assumptions. You should converge on an increasingly accurate forecast which, after all, is the goal of your modelling.

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Company Pulse business health check

Top tips for financial modelling

Financial models are useful business tools. In our view, they are the only reliable way to quantify a business plan. The model may be of a specific business case, perhaps to evaluate a proposed investment, or of the whole business. Financial models come in all shapes and sizes, including short-term cash forecasts, annual budgets and 5-year business plans.

However, financial models have come in for some bad press, particularly as the essential underpinning of complex financial products. And some financial models quickly fall out of use through being unrealistic, overly complex or too cumbersome to use.

But these negatives shouldn’t put you off financial models – they are very effective in helping you understand your business better, and allowing you to make more informed decisions about strategy, plans and investments.

Here are our ten top tips for business owners in how to build and implement a financial model:

1. Don’t be afraid to take an unconventional view
A financial model doesn’t need to follow your current chart of accounts, although it is advisable to reconcile the model back to your accounts. Businesses often find themselves constrained by current accounting practices, and a financial model is a low-risk way to start realigning the accounts – if you are considering doing something different, your financial model should reflect this.

2. Keep it simple
Models are simplifications of reality. To work efficiently and well, they need to encompass all the relevant factors as straightforwardly as possible. Over-elaboration leads to complexity, opacity and mistakes. Unless you specifically need to evaluate a longer period, limit your model to a maximum of five years.

3. Integrated and commercially-based
Build the model up from commercial activities, so unit sales are based on resources, turnover is based on sales units x price, cost of sales is based on sales units x costs, gross profit is turnover less cost of sales, and so on. Commercial performance should be translated in the profit and loss statement, which is reflected in balance sheet movements which in turn give you cash flows. The four elements: commercials; P&L; balance sheet; and cash flow, should be fully integrated.

4. Model each category separately
Keeping each product category, line of business or territory separate allows you to evaluate differing performance (and in the case of overseas territories, allows you to model exchange rates effectively). Your model should have a single layout that applies to each category, each having its own commercials, P&L, balance sheet and cash flow. These can then be consolidated into a set of whole company views. If you have a number of (relatively) immaterial products or activities, it’s probably best to lump these into ‘Other’ – but be prepared to break out any that are found to be material.

5. Separate logic from numerical assumptions
Hold your numerical assumptions together on one worksheet and label them clearly: these can be single point assumptions (e.g. a discount rate) or variable assumptions, by time (e.g. annual pay increases), product category (e.g. cost inflation) or territory (e.g. distribution costs). Separating the logic from (numerical) assumptions means that assumptions can be changed easily if required – this also makes sensitivity analysis a lot easier.

6. Provide summary output and use charts
The summary output should be boiled down to a few top-level lines shown on an annual basis. It’s easy to drill down into the detail if you need it, but it can be difficult to spot the key messages if too much output is presented. Use charts to illustrate and complement numerical analysis – a dashboard-style usually works well.

7. Ensure easy updating
You should update your model regularly with actual performance, so consider ease of updating at the design stage (even in a one-off business case, as you’ll want to review what the actual results were). If the financial model is to have any longevity, you should also permit new products (etc.) to be added easily.

8. Reconcile the starting position
It is essential that you can reconcile the model’s starting position to your accounts, personnel records and any other key inputs, and that the initial balance sheet balances. Whenever you update the model with actual data, you will need to check it still reconciles.

9. Include sensitivity analysis
Every financial model should include some form of sensitivity analysis: what happens if sales are X% down on forecast or payroll costs up by Y%? You may need to provide for scenario analysis, looking at a number of scenarios, each of which has an internally consistent set of assumptions. You may even want to use the Monte Carlo method to generate a large number of outputs with key variables randomised, and then review the range of outputs to get a sense of the most likely outcome.

10. Testing, more testing, documentation and sign-off
Test the model thoroughly before use, and have someone other than the modeller carry out the tests. Initial testing should include calibration of the model to ensure it reflects what is currently happening in the business. Stress testing should be employed to check whether the model breaks within its normal operating range and what happens when you push assumptions outside a ‘reasonable’ range. Sensitivity analysis tests allow you to check input-output relationships and be confident that key assumptions and variables behave as expected. Once you are happy the model performs well in testing, it is useful to allocate a business owner for each of the main assumptions, and reflect to them in the model’s documentation. Finally it is essential to gain business sign-off for the model ideally from the board or, in an owner-managed business, from the business owner.

Financial modelling is an essential tool for all but the smallest of business and it is vital that business owners and managers understand how to deploy a financial model and how to get the best from it. We hope these tips are a useful start.

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Company Pulse business health check

Business Transformation – ‘Eating The Elephant’

At some point, whether due to mergers, cut backs, new products, new business models etc. most organisations at some point will initiate a “Transformation Programme” or “Change Programme” in which, as George Harrison put it, “All things must pass”. Unsurprising perhaps in the ever moving 21st Century business environment? Maybe not but what is surprising is that, in many cases, more thought and planning is out into deciding a sufficiently impressive name for this magnum opus than into a comprehensive design and delivery plan for it. For instance:

  • It is not uncommon to see the posters go up, the press releases out and the mouse pads imprinted for “Programme GeeWhiz” while management still haven’t decided what this actually is and most staff are completely unaware of the existence of it at all or what role they might have in it.
  • If anyone does have an idea of what its about then it is probably only a small part – they can only see a part of the “Elephant” so no one knows what the whole one really looks like yet.
  • Most of all the management team can fail to realise that a transformation programme is not just another change project – by nature it is holistic – impacting on all areas of operations with many interdependencies and complexities so no area or persons can opt out or assume non involvement.
  • If any transformation start off this way then it is almost certain this uncertainty and communicative confusion will remain throughout the programme up to and including the acceptance of, recognition of and quantification of success for any outcomes.

To avoid this sorry state takes only a few underlying pre-requisites:

1) Forget the Name – start with REALLY understanding why you want to start this programme – “Why are we doing this?” Amazingly many organisations can’t clearly articulate this. Consequences of starting in this way will be endless scope creeps and uncertainty that nobody will feel satisfied at any stage. You simply can’t do a “design and build’ make it up as you go approach with such comprehensively impacting change. You must have a clear reason/driver for it and a clear vision of the end state before starting.

2) Have a champion with real clout in the organisation – preferably the CEO – A high-level executive buy-in for the change will help both sell and maintain enthusiasm and support for the duration of the programme. If this person can regularly and clearly state the vision in terms all can relate to then it will be worth ten project managers working in a fog.

3) Ensure the senior and middle management really understand the impacts on their areas and don’t just pay lip service to the Chief Executive:

  • This is the holy grail of a successful transformation programme. Many programmes fail or drag because these people only realise the impacts well into the programme and then start withdrawing support or making changes.
  • At the outset, change is as much about ensuring buy-in from executive and functional leaders within the organisation than actual operational changes themselves. Each of these managers need to fully understand and buy in to the implications of the programme for them and what is required in the programme of them, their business areas and their people.
  • This will also have an added benefit in driving the overall behavioural/cultural change which is often required to work within the new operational environment. The supportive and “lead by example” visible behaviour of leaders and key role players will visibly speak to the new way things should be done. Over time staff will mirror this until the new ways will become “emprinted” permanently.

4) Build a Foundation of Good Governance bare essentials to ensure a successful achievement of the goal are:

  • A clearly defined, scope managed business case – i.e. you know what you are trying to achieve and what it will look and feel like when you do achieve it and any changes to the goal in flight will be reflected in the expectation of the look and feel of the outcome. An overall programme manager who understands all the disciplines involved and how to manage them all holistically towards the end goal
  • Relevant numbers of project managers to take responsibility for specific outcomes within the overall delivery of the goal.
  • Defined best practices, controls and measures for Project progress, review and tracking governance.
  • A programme management office to set, and report on those PM governance practices.
  • Be happy with your success – if you achieve what your vision was then acknowledge it – don’t look for additional benefits that were never promised – the “ Oh I thought you said we would get xxxx from this…” crocodile tears disappointments stated are often from managers who did not fully participate in all of the previous steps above.

But as a last word on governance – I return to the first words: ” A clearly defined, scope managed business case”. If you’ve defined what you want and managed as above you will get it – so be VERY clear on the what……….

“As long as I sit in this chair, all future catastrophes will be planned by me.” (‘allegedly’ – President George W. Bush)

“Don’t worry, I have plans: Plan A – Mess up a perfectly clean house. Done that.” (The Cat in The Hat (movie) – Dr Seuss) –



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Company Pulse business health check

How can your business refinance its debt?

Over the last few years many businesses have found it difficult to refinance their debts. Although the overall economy is improving, most evidence shows the position is not getting any easier. This should not be surprising. Banks are still repairing their balance sheets which reduces their ability to lend. The situation will probably only improve slowly as some banks may still be carrying doubtful quality loans, many are still paying compensation for previous mis-selling and all need to meet tougher capital adequacy requirements. Banks are responding by demanding tougher terms from the businesses they are financing, in particular:

  • Higher margins – for example, businesses that were able to borrow at margins of 150-250 basis points over LIBOR three years ago may now only be offered finance at LIBOR + 300-450 bps
  • Lower loan to value ratios – whereas it was common to be advanced 75-80% LTVs before the credit crunch, 60-65% is now more typical
  • Tighter financial covenants, particularly in respect of EBITDA multiples and debt service (cash flow available to service interest and repayments)
  • More intrusive monitoring of business performance

In addition, banks are conducting more rigorous due diligence before advancing new loans. Consequently, the refinancing process now takes longer with banks’ credit committees requiring greater disclosure from and asking more questions of potential borrowers. Against this tough background, there are some actions you can take to improve the chances of refinancing your business. If your business holds debt that is due to expire in the next two years, you should really start planning your refinancing now. First, you should prepare a robust business plan. Your business plan will need to be realistic – banks are likely to challenge many of your assumptions – and you should carry out sensitivity analysis on the key variables in your plan. You can expect prospective lenders to ask for sensitivities, probably with (what you consider) fairly dramatic downsides on your base case. Second, you should analyse your cash flows in the period before you are due to refinance, as well as after, and maximise available cash – in case you aren’t able to refinance all your existing debt. With reduced LTVs and a more pessimistic valuation of your assets and future cash flows, it is likely that any new advance will be less than your outstanding debts. You therefore need to prepare for this by having more stringent criteria for your investment decisions and by careful management of working capital. Otherwise you may have to inject equity into your business to cover any shortfall. Third, you should research which lenders are currently providing finance in your sector. You may find that your existing lender is not the best choice (even if willing to lend) as many more non-traditional financial institutions are available than in the past. A well-prepared business that can pull together a credible proposal, underpinned by a robust business plan, and pitch that proposal to the right lenders should be able to refinance successfully, even in the current difficult financial environment. After all, banks are in business to lend – you have to make the lending decision easy for them.

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