Financial modeling

It struck me as peculiar that my accounting degree did not include any financial modeling. It was in the real world that I learned, initially as a CFO, and then in finance.

As a working capital financier, you see plenty of cash flow projections. Working capital finance is usually needed because people have made mistakes with their modeling at the outset. Financiers have to have own models into which they plug the numbers. It’s better than trusting the sanguine figures that are usually presented.

So that’s what we did.

As the spreadsheet guru, I was tasked with creating a model that integrated the balance sheet, income statement and cash flow projections.

Getting all three to balance is tricky, but crucial. Errors in assumptions become evident as the ratios go out of kilter, and that let’s you know if the numbers can be trusted.

Once the model is working, the starting point is to enter the last three months figures. If the assumptions and calculations are right, the most recent balance sheet will pop out from the input. If it doesn’t there are errors. Fix them, and you’re on your way.

The assumptions are key. They will guide the strategic planning, and the executive that has a grip on them is likely to succeed.

One of the best tools for getting a feel for the key factors in a business is also one of the simplest: break-even analysis.

To the uninitiated, break-even analysis is like a magic trick. Sitting in a pub, you can scribble down the variable expenses, then the fixed expenses, calculate the contribution, and tell a desperate friend why his business is struggling, and how long it will take to fix.

The financial model must include the results of a proper break-even analysis. Then, slotting in past figures will immediately reveal any misallocation of fixed and variable expenses.

The exercise of entering past figures has another benefit.

It provides the executives with confidence that the model works, and the understanding that by continuing to enter results they will know in advance whether something is out of line.

They become proactive.

They look good.

They are good.

Canada’s book cooks

In a recent article, The Economist reported that the Canadian budget uses the accrual basis of accounting for its revenues, and the cash basis for reporting its more detailed spending.

Accounting like that provides a government with the opportunity to cook the books, Enron style. The Public Sector Accounting and Auditing Board (PSAAB) of the Canadian Institute of Chartered Accountants provides recommendations for how Canadian governments should account, but has no authority to enforce their recommendations.

In a speech given in 1982 by PSAAB’s first Chairman, N.G. Ross, he posed the following question to a group of legislators – why might governments “cook the books”? The answer – because governments, like any organization, do not like to report bad news. Bad financial news can constrain policy and spending initiatives that a government wants to introduce.

In 2003 a Liberal finance minister changed the budget to full accrual accounting. But the more detailed spending estimates were still accounted for on a cash basis. So, Canada’s anticipated expeditures do not follow the matching concept, one of four founding principles of accounting.

And the government no longer reconciles the figures, the most basic accounting control mechanism.

To forensic accountants these are signs that things are amiss.

And it suggests that one of the world’s leading democracies isn’t.

More at:
Something doesn’t add up
Perspectives on Accrual Accounting

First loss is the best loss

In finance there’s a saying: the first loss is the best loss. The financier has loaned money, the borrower is unable to repay unless more money is advanced to “fund the imminent turnaround”. No-one likes to lose money and it’s also an admission of failure. Lending more money is an easy mistake to make, even when all the signs say that’s it’s a bad idea.

Greece was insolvent before the first European loans were granted, and no amount of lending could fix that. The five year recession, heightened by austerity have made that worse. The Greek economy is now 20% smaller, and the loans are a lot bigger. The first loss would have been the best loss, and now the loss will be worse.

Even with the “positive” outcome of the June 17 election it is probable that Greece will have to leave the Euro in the future.

The “good news” is that Europeans got a real fright about what could happen once Greece leaves – a run on the Greek banks, followed by runs on Spain’s banks, then Italy, followed possibly by France. They are no longer deluded about the possible consequences. Politicians are having to consider real solutions, not the band-aid remedies that they’ve tried so far.

The Euro’s design flaws need to be repaired through greater fiscal federalism. A ‘banking union’, with a European system to wind down or recapitalise troubled banks and a Europe-wide bank-deposit insurance scheme, would help break the feedback loop between weak banks and weak sovereigns. A ‘fiscal union’ in which all or part of the national debts are mutualised as joint Eurobonds would stop markets pushing sovereigns into insolvency, and would create a European asset that banks could hold. Moreover, if these were financed through federal taxes Eurobonds would be even more of a safe asset. Instead of providing liquidity indirectly to banks, the ECB could declare that it stands fully behind solvent sovereigns, just as the Fed stands behind the American government.

The Federalist papers of 1787-88 argue that trying to coerce a group of sovereign states to follow common rules is ultimately doomed. Leagues and confederacies are like feudal baronies: sooner or later somebody breaks the rules. And attempts to bring them into line lead to anarchy, tyranny and war. Europe is not at the point of war, but many a citizen feels an economic conflict is well underway.

For Alexander Hamilton, the leading author of the Federalist papers, the solution to the problem was to create a strong American federal government, acting directly on the citizen rather than through the constituent states. With the adoption of America’s federal constitution, Hamilton became treasury secretary. The federal government assumed the war debts of the ex-colonies, issued new national bonds backed by direct taxes and minted its own currency. Hamilton’s new financial system helped transform the young republic from a basket-case into an economic powerhouse.

Even discussing these measures is a huge challenge. The most influential politician in Europe, Angela Merkel, is starting to mention some of them. “She is a clever woman who is not an economist, surrounded by economists giving her contradictory advice,” says one close observer.

There is an influential group of German economists who are reminding anyone who will listen about the history lesson from the Weimar republic: printing money led to hyperinflation, then economic chaos, political extremism and ultimately to catastrophe for all of Europe.

The Economist

Inflation need not be the result of central bank funding if it’s carefully applied. The cure should not be made to kill the patient.

Even if the politicians finally see sense, it’s unlikely that the citizens of Europe will agree to such drastic measures. Perhaps another fright will help them.

More at:
Between two nightmares Angela Merkel is drawing the wrong lessons from the chaos of German history
Fiscal consolidation
Europe’s Achilles heel Amid growing risk of a Greek exit, the euro zone has yet to face up to the task of saving the single currency itself
The euro crisis Share a currency, with them?
The future of the European Union (part 2) Don’t count on a Hamiltonian moment
Germany and the future of the euro (1) Is Grexit good for the euro?
The future of the European Union (part 1) Soviet collapse or Germanic reform?
Worried Banks Resist Fiscal Union
Greece as Victim
EU unveils its vision for the future of monetary union
TOWARDS A GENUINE ECONOMIC AND MONETARY UNION