Galileo Galilei said that about 400 years ago. He didn't say exactly that but it was pretty close and it applies today.
Cash flow models provide us with understanding of what the market is saying and allow individual companies to express their view of the future back to the market. So why are most models so frustrating to understand?
Investors, bankers and corporate executives invest thousands of hours in developing and digesting cash flow models. Some banks have a template (which inevitably gets bastardized the second it is released), some institutions have their proprietary sheet they insert into the client's model (which leaves 3rd parties wondering which answer is the right one) and clients tend to have a "bespoke" format (where overly complex is opted for over just ordinary complicated).
CFA's learn Financial Statement Analysis in their first year. Investment Bankers are sent to training courses like Financial Edge where they learn Financial Accounting and Financial Modeling according to GAAP / IFRS. MBA students who go on to become CFO's learn Financial Reporting and Control during their first semester.
Communicating through the medium of financial statements makes sense but is rarely done in my experience. Accountants understood the importance of verification long before Nasa figured out that spacecraft failures occurred because of a breakdown in verification process. Linking the three statements together embeds a verification system into the model which immediately signals to the user if the system has been built correctly or not.
Two statement financial reports have been around a long time. They've been officially required in the US since 1933. The third statement, the cash flow statement, joined the other two as a requirement in 1988. Nuances in accounting rules might change the information each contain or the basis behind some of the numbers but the concepts of each are the same from jurisdiction to jurisdiction.
Expenses go on the Income Statement, capitalized (which simply means "divided by", credit goes to Michael Mauboussin for teaching me that simple lesson in an email exchange a year ago) items go on the Balance Sheet and changes from one period to the next on either of those two are captured in the Cash Flow Statement.
Tip #1 - Output linked financial statements
"Profit and Loss" outputs are the closest thing I've seen to a standard. Cash flow items (capital expenditures, changes in debt) get thrown into the PnL, taxable income is misstated and outputs are, at best, a vague picture of what the future might look like.
Verification of the PnL output is where those legacy models really break down. Forensic model auditing begins and a few hours or days later someone emerges from their screen with bloodshot eyes and with a thumbs up or thumbs downs.
Linked statements address that. The balance sheet won't balance if the outputs are linked and the inputs are incorrect. Spoiler alter, this is a frustrating characteristic of these models. Doing them correctly takes time at the front end of the process. But it saves everyone else the frustrations encountered throughout the process of using the model.
Tip #2 - Eat your veggies
Accounting principles fuel cash flow models and analysis. You might need a single serving of veggies if you are a specialist in one industry. You might need veggies at every meal if you are a generalist and looking across multiple sectors.
Hardly a year goes by without some form of an accounting "scandal". Carvana is the latest. Fundamental topics such as revenue recognition can prove to be daunting when satisfying a performance obligation is more than just delivering a car.
Don't skip those veggies.
Tip #2 - Journaling for model health
HBR has innumerable articles on the benefits of journaling and Amazon's virtual shelves are filled with books on the same topic. Everyone has two screens (or one giant wide screen) that they work on today. Open a word document next to the excel model and keep a journal of what's going on behind the financial statements.
Besides making your model healthier, a journal can serve as a user manual when you send the model to investors, lenders, accountants, etc.
"I pretend that they’ve been away for a year and I’m reporting to them on their investment and I tell them what I’d want them to know before they made a decision" – Warren Buffett's response to how he writes his annual letter to shareholders
Tip #3 - "All models are wrong, but some are useful"
George Box in a 1976 paper published in Journal of the American Statistical Association noted, "Since all models are wrong the scientist cannot obtain a "correct" one by excessive elaboration."
Every line in a forecast will have a point where each minute invested to model that one item more "accurately" will have diminishing returns. I've quoted Howard Mark's memo previously and it applies here, again. You can't eat IRR. Model outputs aren't going to make you any money. Only actions taken as a result of those outputs can...so make sure the model is useful.
Purpose of the model should be defined at the outset and maintained in focus throughout the process; models assist in making decisions. They don't magically set boundaries on reality and provide stops on losses (or gains). They can't provide certainty where it simply doesn't exist.
Take a step back if you can't make a decision with the current state of the model. Ask yourself, "if I had a more granular, accurate understanding of future (revenue, costs, tax, etc), would I be able to make a decision or is the (revenue, cost, tax, etc) structure of the business too complicated and therefore the future too uncertain?"
KYC
I'll end where every modeling process should start; Know Your Customer. Your customer can be you (individual investor), your firm (a fund), your lenders (an industry player), your investors (all of the above) or your acquirer (industry competitor). More importantly, it is likely to be ALL of them at one point in time or another.
Financial statements are familiar to each of those potential customers. Linked statements have a built in verification system to give everyone confidence the model has been built correctly. Keep a journal and send it as a user manual to your customers. Make sure the model serves the intended use of your customers.
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