Charles Darwin’s ‘survival of the fittest’ is a concept that most people with some sort of rational background agree to. Would Darwin say that these principles are working in financial modelling?
Let’s say that Charles Darwin was given the task to set up the rules for evolution of financial modelling as an industry and think for a minute about which things he would change.
Genetic degeneration through ‘keeping it in the family’
Many organisations have their own internal ‘financial modelling style’. This is great of course in that it ensures internal consistency and therefore reduces modelling risk.
There is a risk however that in the efforts of keeping a financial modelling standard intact an organization stops the intellectual exchange of thoughts with the outer world and simply ignores outsiders’ comments on how the financial modelling standard could be improved.
There is a particularly big risk of genetic degeneration when a financial modelling team is managed by the same person for an extended time. The vast majority of financial modellers (including myself) would like to think that they can be objective and have the capability to review external input and incorporate it into their own world.
Sadly, this generally only results in minor tweaks to an existing modelling standard as most people are reluctant to completely change the way they do things (true for me as well….).
What would Charles Darwin recommend to avoid genetic degeneration of financial modelling standards?
- Schedule annual brain-storming sessions where the internal financial modelling standard is re-invented from scratch
- Ensure that new joiners to the team document their initial thoughts on the internal standards and suggest improvements based on previous experience
- Ask your clients, investors, lenders, model auditors or friends what they think about your financial modelling standard
- Reward change and invention through google style ‘time to think’. Allocate 10% of your time to develop new ways of building financial models, or even simpler, to review how other people are already doing it
Supporting genetically defect financial models
Many second grade financial modelling standards survive too long due to the support they are getting from within certain parts of an organisation. This is generally (not surprisingly) the case when the standard is used to generate a large amount of money, i.e. the financial models are used to win bids and therefore the sacrifice of low modelling standard is easy to live with.
This argument is fine as long as you would destroy the models post bid, but to this date I haven’t seen this happen. Bid models hang around for a number of years with a confused CFO trying to de-code what the deal team was really trying to do…
Are there ways of re-addressing the support for poor financial modelling standards?
- Review the progress of your financial modelling standard through the life cycle of a financial model – pre-feasibility, feasibility, bid, equity raising, debt analysis, covenant monitoring, budgeting, debt re-financing, divestment, re-structuring. How much is the poor financial modelling standard really costing you in lower productivity, staff retention and pure frustration?
- When you identify which stage is causing the biggest stress on the financial modelling standard then you need to bring this problem back to the source. Don’t just fix it in the current model that is having problems, but rather go back and update your financial modelling standard documentation, training material and templates to avoid the same problem for others in the future
Lack of predators to test the ‘fitness’ of a financial modelling standard
Most financial modelling teams don’t expose themselves to predators – i.e. people who are trying to kill your financial models. Many financial models are used for analysis by external parties but generally the feedback is in regards to the numerical output rather than on the financial modelling standard.
What you get then is similar to a situation where there are no predators for a certain species on an island and this species can grow without limitations. A bit like with the Kangaroos in certain areas of Australia.
How can you create virtual ‘predators’ within your team or organization?
- Create a reward program for complaints on your financial modelling products to encourage external parties to give you constructive feedback on what is not working so well with the financial model you built for them
- Have a semi-public screening of recent models for a wider audience every month/quarter and take the time to listen properly to the feedback in a relaxed environment (bring beer)
- Give new joiners to the team the challenge of ‘killing’ the current standard by building something that’s bigger and better. Reward ambition, not results.
“We don’t even have a financial modelling standard!?”
Look, if your team doesn’t have a modelling standard already then don’t be too worried. That is a great opportunity to create one that really fits your needs, and it is almost always easier to start from scratch than to improve something that already exists. My key tip before starting would be “stop, right there!”
Why would you develop something new when there are people out there who have devoted their lives to financial modelling and you can simply adopt their standard? You wouldn’t start learning C++ just because you want to write a document and need to develop a word-processing software so why would you develop a financial modelling standard from scratch?