George E. P. Box famously said, “All models are wrong, but some are useful.” Financial analysts strive to build accurate models that simplify yet reflect the complex adaptive systems in scope. In the financial markets, legions of PhDs unleash quantitative methods to identify and arbitrage inefficiencies with the prospect of outsized return relative to risk.
These abstraction models are part art and part science, with assumptions for probabilities, outcomes, non-linear relationships, and stochastic processes. When combined with the acumen of position sizing and the power of technology, bets are laid with winners and losers determined by the market. Sometimes the models are very useful with fortunes being made, and often they are really wrong with hedge funds suddenly shutting down.
In the corporate finance world, a less sophisticated, though vitally important, model is developed annually—the budget. This prospective view of the income statement, balance sheet, and statement of cash flows can take six months or longer to compile with input from multiple stakeholders in all reaches of the organization.
Model approaches vary from company to company
Some companies begin top-down with revenue and expense goals pushed down to the business units and support organizations. Others begin bottom-up and build the budget based on resources required for expected outputs. Notably, a few organizations have brought back zero-based budgeting to force teams to rationalize expenses each year without starting from a prior year baseline. Most financial planning and analysis (FP&A) teams update the budget monthly and this becomes the benchmark known as the forecast.
But when the model is off…
While these corporate finance budgets and forecasts historically haven’t used advanced analytics to project revenue and expense, they have been useful in measuring actual results against plan as well as reflecting and communicating the corporate strategy. The deployment of budget to certain products, customer segments, channels, geographies, and functional organizations sends a strong signal as to tradeoffs inherent in the strategy. Budgets also shape organizational behavior and guide expectations. Since the goal is typically “beat and raise,” when the model is off and actual performance misses, shareholders react.
Historically, the cadence of finance and accounting has been one of annual budgets, monthly forecasts, and multi-day hard closes. While this periodicity has become standard, it puts finance organizations in the position of using estimates and leading indicators to try and manage the inter-period latency.
How is real-time planning changing finance?
With dynamic, real-time planning and consolidation systems now available, finance can incorporate feedback into models based on new information and rerun the updated forecast at any time during the month. These continuous accounting models also simulate eliminating entries and other adjustments such as equity pickups that provide the management team with instant readouts—a great way to spare management the risk of surprises. Leaders can now proactively address challenges for immediate course correction.
CFOs are driving analytics into the finance organization to not only improve the accuracy of the financial plan, but also to provide real-time visibility into the ever-changing forecast. The CFO as strategist and storyteller is leveraging a new wave of analytic technology to create value for the enterprise.
So what’s the future of analytics in finance? In my next blog, I will discuss the ascent of the corporate finance quant. Stay tuned!
If you want to learn more about how to leverage analytics and technology in finance click here.