Every business manager knows the importance of cashflow management and the old saying ‘cash is king’. Still we regularly see companies embark on strategies that, due to insufficient evaluation of cashflow forecasts, don’t maximise the risk/reward equation of the proposed strategy. Why?
In times of economic uncertainty and changing market dynamics the importance of strategic business planning and forecasting is greatly increased. Companies face a constant need to evaluate the impact of fundamental business drivers including sales pipelines, client behaviour, competitors, capital budgets, tax environments, currency movements and product performance.
Rickard Wärnelid’s fifth article on best practice financial modelling for CIMA, ‘Cash is still king, implementing strategic analysis’, discusses three methodologies for evaluating the financial impact of an organisation’s strategic direction and outlines the key considerations required to ensure successful implementation of strategic analysis.
The world of financial modelling is trending towards algorithmic forecasting based on trend analysis and statistics. This method involves:
- operational and financial parameters are forecast based on historical results using trend analysis and correlations
- recalibration of forecasting parameters is performed in every period to ‘learn’ from historic data
- it is assumed that the interdependencies of various parameters can be calculated and modelled based on historical information.
Discrete scenario analysis
Discrete scenario analysis can be described as the more classical approach to forecasting and is based on the following:
- forecast operational and financial parameters are entered as assumptions
- the entered assumptions drive higher level calculations resulting in forecast financial statements
- only limited trend and correlation analysis is used for forecasting
Sophisticated forecasting models
There is no strict definition of when a business is ready for a more sophisticated forecasting model but Rickard stresses that some basic questions quickly rule out if a business isn’t ready and also if this is something that a company should explore.
Ask yourself these questions:
- can you explain (using mathematical logic) the correlation between your key business drivers?
- do you have reliable historical data available for your key drivers as well as the financial results?
- does your organisation have people with statistics, mathematics and business analysis backgrounds?
- do you enjoy talking about ‘correlations’, ‘variance’ and ‘distributions’?
If you have answered ‘no’ to any of the above questions then you may be better off sticking to the old proven strategy of using discrete forecasting scenarios.
Improve your financial forecasts – understand key business drivers
Having a well-functioning financial model and forecasting process is a critical step in ensuring competitive strategic planning and sustainable business profitability. For companies who want to improve their forecasts and understand more about key business drivers, consulting firms, such as Corality, can be of assistance.
Rickard stresses the importance of initial scoping meetings to define the scope and focus of the model and establish company-wide buy-in. This will ensure the financial model developed caters to all stakeholder needs and therefore will be accepted and used.
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Corality’s article series for CIMA