A robust financial model allows management and other users to analyse various scenarios and make decisions when assumptions, and consequently the outcome, is uncertain.
In any business, planning is a difficult task for management given the number of uncertainties and various potential outcomes, which is emphasised in today’s economic environment resulting from COVID-19.
A financial model can help to alleviate difficulty in decision making and minimise potential risk, by allowing assumptions to be clearly stated and imposing a logical calculation of the likely outcome should those assumptions hold true.
Management can also use this tool for scenario analysis and compare best and worst-case scenarios to ensure all bases are covered when making critical decisions.
Another benefit of a well-constructed financial model is once these assumptions change and crystallise, the financial model can be updated, and decision makers can have the most up-to-date information on the likely outcomes for the business.
There are many examples of how businesses can use financial models for strategy and decision making: forecasting key financial information such as profit and cash, assessing the likely return on a particular project, comparing options for debt or equity raisings and valuing businesses for a potential merger or acquisition.
In all of these cases, the benefit of using a financial model in decision making is outputs are clearly calculated and communicated, and should certain assumptions be challenged or used in a scenario analysis, assumptions can be changed by any user and outputs will update in real time.
A practical example of how financial models can support business strategy and decision making is the recent Energy Fiji Limited transaction completed with Fiji banks totalling FJ 335M. Several banks were invited to submit tenders for financing Energy Fiji, with HLB Debt Advisory acting as the core independent adviser to Energy Fiji in this transaction.
In order to submit their tenders, the banks needed an understanding of what the key ratios of the business would be, such as debt covenants. As the advisers, HLB prepared a financial model which showcased these key ratios based on forecast financial information. In building this forecast model, there were a few unknown assumptions such as the dividend payment ratio and capital expenditure, as these decisions were yet to be made by management.
It was important the financial model included a scenario analysis summarising how these key ratios would differ if different assumptions were used to calculate the forecast financial information, as this allowed the banks to assess the key ratios under each situation and ultimately allow them to submit their tenders despite uncertainties relating to the forecast position. Without the aid of a financial model and scenario analysis, the banks would not have the necessary information to be able to make an informed decision.
Furthermore, the management team and Board of Energy Fiji Limited used – and continues to use – the financial model to assist them in critical decision making and covering key items such as major capital expenditure planning, dividend payments and future equity-based transactions.
This article was written by Natalie Tieck from HLB Mann Judd Sydney.