BUSINESSANALYSIS LIFECYCLE

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FROM THE BUSINESS CONCEPT TO THE FINANCIAL MODEL

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THIS GUIDE

BA BANkINg & AdVISorYf fASt fINANcIAL

ModELLINg

E

pf proJEct fINANcE

EN ENErgY & NAtUrAL rESoUrcES E ENtErprISE

rEportINg & ANALYSIS

fFAST FINANCIAL MODELLINGUseful, practical information about FAST financial modelling, managing modelling projects and good modelling practice.

BABANKING & ADVISORY Targeted at, but not exclusive to, banking and advisory practice areas, exploring modelling topics like credit analysis, debt structuring etc...

ENTERPRISE REPORTING & ANALYSIS Useful information and practical guidance on the apllication of modelling discipline and standards to improve business decision making.

ENENERGY & NATURAL RESOURCES Insight and practical guidance on the aplication of good modelling practice specifically related to these often complicated business areas.

pfPROJECT FINANCE Focussing on the kind of transactional modelling typically associated with the development of infrastructure, PFI and PPP projects.

coNtENtS

1. thE BUSINESS SItUAtIoN

1.1 UNDERSTAND

2. coNcEptUAL ModELLINg

2.1 ENGINEER

3. SprEAdShEEt ENgINEErINg

3.1 ANALYSE

4. ModEL INSIghtS

5.1 COMMUNICATE

5. MANAgEMENt

4.1 INTERPRET

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The Business Analysis Lifecycle framework was developed by Tom Grossman. Like all works of great insight – it now seems obvious. However, when we first came across it, it was a real moment of revelation for me. It makes clear and explicit what had been unclear and implicit previously. At F1F9 this framework has helped us to explain what it is that we do (“spreadsheet engineering”) and what we rely on our clients to provide us with (“conceptual models”). In our training business, it has helped us as we explain to our students the different skills that they will need if they are to add value to their modelling assignments. We are deeply grateful to Tom.

ABOUT F1F9We build financial models, relationships, knowledge and confidence.

We specialise in knowledge sharing and tailored training, so our clients are able to understand and maximise the use of financial models that are critical to their business success.

We’re there wherever, however and whenever you need us — building models or teaching you to build your own; providing a well-informed, reliable, guiding partner every step of the way; transferring as much or as little knowledge as you need; and ensuring you know the route you're taking is the right one for you.

SPECIAL THANKS

f

“Most people seem to start at the beginning. That is, they start modelling by entering some inputs into a spreadsheet, and work forwards towards whatever it is they think they want to compute. We call this input oriented modelling.

Input oriented modelling is analogous to building a house without blueprints. If the house is small, and similar to another house you built recently, and you genuinely know exactly what you want, you can get away with this approach.

However, it does not scale well to larger or harder models, and over-reliance on this technique can cause problems.” Tom Grossman, 2005

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BUSINESS SItUAtIoN

MANAgEMENt INSIghtS

coNcEptUALModEL

SprEAdShEEtModEL

ModELINSIghtS

ModEL worLdrEAL worLd

‘Interpret’

‘COMMUnICAte’

‘UnDerStAnD’

‘AnAlySe’

‘enGIneer’

“The Business Analysis Lifecycle“by Tom Grossman.

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thE BUSINESS SItUAtIoNAt F1F9, we think of spreadsheets as a laboratory: a place for analysts to test business hypotheses. The purpose of the spreadsheet financial model is to understand something about a specific business situation: should we invest? Should we change our capital structure? Should we undertake a project? Can we afford to hire more staff? By how much do we need to cut costs?

Since models exist to provide answers to these questions, the model should be built with the questions in mind: output oriented modelling. Somebody in the business asks a question. The analyst responds with: “we’ll need to model it.”

In order to model it, you first need to understand what it is that you are modelling.

UNdErStANdIn order to understand what it is that you are modelling, it is a good start to consider what makes it risky. Here are some classic risks that might be relevant:

• This deal is a one off – there are no precedents; • It is has huge political significance; • It involves numerous key stakeholders – and how they work together is not yet clear; • Nobody trusts the demand forecasts; • There are ten thousand lines of raw data to accommodate; • Cost estimates have a margin of error of + / - 30 per cent; • The financing structure is not yet clear; and • The terms under which revenue is generated are complex.

Risks might fall under different categories. So project risks are risks that apply once the deal has been signed. We have seen project risks classified under seven main headings: construction; design; technology; demand; relevant cost; third party revenues and residual value.

Procurement risks apply up to deal close. These include the risk of approvals not being granted, overruns in budget estimates and financing not being available on favourable terms.

Modelling risk deserves its own category and we encourage modelling team to undertake their own assessment.

1.

1.1

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coNcEptUAL ModELLINgWe have taught analysts from hundreds of companies to build financial models. Financial modelling proficiency re-quires skills that take time to acquire, develop and perfect.

Sometimes the difficulties students have are related to how to build their model. More often, difficulties relate to what it is they need to model. Once the modeller understands how a particular area of a business works commercially, it is much more straightforward to create a spreadsheet model. We recommend that students begin with a sound conceptual understanding of what it is they must model. If they are confident that they understand how an area of the business works, they may press on and open up Excel. If not, they should spend the time required up front to acquire that understanding.

Conceptual understanding may be acquired by talking to people within the business who do understand the business situation, or by creating flow diagrams that set out the commercial and financial ingredients of the business.

It is helpful to start with the line item being modelled—for example “Revenue”—and to keep asking the question “what drives that?” until you cannot go any further. The sample flow chart below shows what this might be like.

2.

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2.1

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ENgINEErJust as a key part of assessing the business situation is to understand the risks asso-ciated with that business situation, so a key part of assessing the conceptual model is to understand where the complexity lies. A good modelling solution will be engineered with complexity in mind. Let’s consider some conceptual models and identify where the complexity lies.

Interest needs to be added to a bank account and interest is chargeable on interest: identifying an appropriate balance for interest calculations is what makes this complex – and that is all conceptual. The spreadsheet solutions can be both appropriate and simple.

Dividends are tested against distributable profits and cash before distribution: matching the detail of the test with a particular jurisdiction’s legal requirements is what makes this complex. The complexity is conceptual.

Costs charged to the income statement are paid six months later: this business situation is easy to understand, but the spreadsheet engineering is not always straightforward. Most solutions fall back on complex Excel functions such as HLOOKUP, OFFSET or SUMIF.

Forecast inflation rates vary and sub contract agreements have their own indexation pro-visions that need to be aligned with the main project model: this business situation is not always easy to understand and the spreadsheet solution is frequently complex.

A good modeller – on determining that complexity lies in conceptual understanding – will shut down Excel and start sketching: mind maps, wiring diagrams and graphs. The good modeller will consult with colleagues, test their understanding through dialogue and ask others to describe how they have addressed similar challenges.

A good modeller – on determining that complexity lies in the spreadsheet engineering – will seek out structures and coding that they have used in the past, will weigh up the benefits and pitfalls of using complex functions and will test their work on a reviewer.

Frequently, there is a trade-off between flexibility and transparency to be made.

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SprEAdShEEt ENgINEErINgEquipped with an understanding of how the business works and an assessment of risk and complexity, you can now create a spreadsheet representation of the business.

It can, and often should, be different people responsible for conceptual modelling and spreadsheet engineering. These are very different skill sets and it is rare that one person is good at or even interested in both. A sensible separation of conceptual and engineering roles will assist in consistent models being built regardless of sector or commercial complexity.

At F1F9 we do not pretend to understand the commercial reality of every business that we are engaged to model. What we bring is rigour, efficiency, flexibility and scalability to the modelling process. Our clients bring the commercial understanding of how their businesses work, and knowledge of what hypotheses they need the model to test.

We use a collaborative Agile methodology to allow the conceptual modeller and spread-sheet engineer to work closely together.

Whereas the conceptual modelling relies on commercial, accounting and financial knowledge, the spreadsheet engineering requires rigorous process and the application of standards.

3.

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31 days to better financial modelling. A free introduction to the basics of FAST financial modelling through 31 free short tutorials delivered daily to your inbox.

The Financial Modelling Handbook. An online resource of FAST modelling guidance.

coNSIStENcY All of our models are built the same way. This is essential for the collaboration between conceptual modeller and spread-sheet engineer that lies at the heart of the Agile approach.

EffIcIENcY Our model build process does not rely on one single mod-eller. As we write this in late 2013 we have more than 40 modellers in the team. Because they are all building models to the same standards, modelling becomes a team activity, rather than an individual one.

rISk rEdUctIoN Models are easier to read, making them easier to review. The collaborative, Agile process means that more people are looking at the model during the build process, which helps to reduce risk.

ModULArItY No two businesses or projects are exactly the same, but there are many areas that are similar. The modularity of FAST models allows us to reuse code blocks where the conceptual model for a particular part of the business is the same as we have modelled previously.

At F1F9 all of our models are built to the FAST modelling standard which gives us the following benefits:

RESOURCESIf you’d like to find out more about applying the FAST Standard to your modelling the following resources might be helpful:

ANALYSE FAST financial models are built with model reviewers in mind. As model reviewers investigate the calculation sheets of FAST models, they will find – on any particular row – either:

• A link to a single source calculation or input; or• A single source calculation. This link based approach is simple, consistent and means that a FAST financial model may be analysed and reviewed using no more than 4 keyboard shortcuts. These are:

• Ctrl + [ to jump back to the source of a link;• F5, Enter to jump back from the source to the destination;• F11 (quick chart) to get a big picture view of calculations; and • Alt M P to throw up trace arrows on a calculation

3.1

ModEL INSIghtSThe purpose of the model is not to show off your knowledge of Excel. It’s to create insights into the business hypotheses being tested. This requires analysis.

A common complaint we hear from senior business people is that building the model takes so much time, there is not enough time left for the analysis.

Although an Agile methodology and the application of modelling standards help to get a better model more quickly, the amount of analysis available will always be time limited. In other words, it is the job of the analyst to produce as much insight as possible in the time available.

4.

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EStABLISh A rEASoNABLE BASE cASE

Good base case values should be based on reasonable estimates. These estimates should lead the model to produce reasonable outputs. Senior people in the business will generally have a good feel for what reasonable outputs will look like. A high level review of the base case is a good sense check.

pErforM SENSItIVItY ANd ScENArIo ANALYSIS

A sensitive input is one where a change in the base case value will produce a significant change in an important output. It is surprising how frequently “plus or minus 5% from the base case” passes for sensible sensitivity analysis. It’s important to look carefully at what reasonable best and worst case scenarios look like.

whErE poSSIBLE, ModEL thE dIStrIBUtIoN

Monte Carlo analysis is where inputs are defined as a distribution, and the model is run hundreds or thousands of times to understand the impact of the range of possibilities across all the inputs. This method recognises that the future is a range, not a point. However it is not always possible to do this kind of probabilistic analysis, and the output is not always readily understandable to others. Where it can be done, using software like Crystal Ball or @Risk, it provides a much richer insight into the risks being faced by the business, and therefore guidance into where management attention should be focused.

The following recommendations may be useful in this regard.

INtErprEtKey to model interpretation is a focus on answering questions that will keep senior decision makers awake at night. Here are some key interpretation questions to keep in mind:

• Does the project always have cash adequate for its needs?• Are the resources adequate to achieve the revenue predicted?• Is the project over resourced?• What happens if demand forecasts do not materialise?• Are minimum expected rates of return being achieved for key stakeholders?• Are growth assumptions in line with industry expectations?• Are operating margins in line with industry expectations?• Are investors achieving cash returns in the most sensible way?• What role does efficient working capital management have in improving returns?• How ambitious is the tax structuring?

4.1

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MANAgEMENt INSIghtS One F1F9 client, David Sugrue, is using FAST financial models to developer solar projects in the US.

This is how he uses FAST financial models to gain management insights:“On Thursday, I used the model to have three very important conversations: one with myself; one with a potential business partner and one with a solar financier (who is also very skilled at modelling).”

“The conversation with myself was hugely useful as the model helped me solve some complex bits of solar financing that had confused me.”

“The conversation with my potential business partner was huge because I could show him exactly how much money we could make on each type of commercial solar sale I propose we target. I am keen to exploit commercial solar systems ranging in size from 20 kW to 150 kW. Up until now, without the model, he had been doubtful of the potential profitability of this segment. Now he is convinced.”

“Finally, the conversation on Thursday afternoon was with a very good friend of mine who happens to be very successful in solar finance. I proposed my business model to him via the model and he was immediately intrigued. I am going to see him next week with the intent of getting him as a backer for my next solar venture.”

5.

coMMUNIcAtE “It’s essential that the analyst speaks about the business, and not about the model” – Tom Grossman

The Business Analysis Lifecycle model divides the world in two – the real world, and the model world. Analysts, and financial modellers in particular, live in the model world. It is a well-ordered world where A leads to B, and where businesses can be neatly represented by calculation blocks and inputs. Most people do not live in the model world. Communicating with people in the real world can be a challenge for those who live in the model world. It is important for analysts to do the work of turning model insights into business insights. Managerial insights are aimed at people who are familiar with the business, and the industry in which the business operates, but who are not familiar with the model.

5.1

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rEMEMBEr thAt thE fUtUrE IS A rANgE, Not A poINt

The future of any business or project is a range of possible outcomes. The question is, how likely is each outcome? When you present the results of your modelling as a range of possible outcomes it helps everybody to think through the risks, including the unknown unknowns.

Just because your base case model is showing an IRR of 14.2345% - don’t be tricked into thinking that this is what is actually going to happen.

The only thing you can say with any confidence about your base case is that it is not going to happen.

tALk ABoUt thE BUSINESS, Not thE ModEL

In truth people do not want to hear about your model. It is your job to translate what the model is telling you into business insights, and then communicate them effectively. Spending time walking somebody through your spreadsheet is rarely a good use of time. Unless they have asked for it specifically, and even then...!

doN’t BELIEVE YoUr ModEL

You are smarter than your model. When you are running sensitivities or changing your model, make sure you have a hypothesis first about how the model is going to react. If the model does not react in the way that you expect, your first position should be that the model is wrong.

Models are wrong more often than we like to think.

When you find yourself rationalising what the model is telling you, rather than looking for reasons why your model does not react in the way that you expected it to, alarm bells should be ringing.

thINk ABoUt whAt INtErEStS thE AUdIENcE, Not whAt INtErEStS YoU

Interesting to model does not mean interesting to your audi-ence, and it does not mean that it is material to the business. Just because something was interesting to model does not mean that it should automatically go into your presentation. In fact, it is a pretty reliable indicator that it should not go into your presentation.

A key skill that allows an analyst to progress to more senior appointments is the ability to communicate insights about the business based on analysis of the model. The following recommendations may help:

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ASk “So whAt?” ABoUt EVErY SLIdE YoU pUt IN froNt of AN AUdIENcE

Every slide must have a “so what?”. If you do not know what the point of a slide or graph is, drop it from the deck. Ask this question of every piece of information you put in your deck. Some analysts think that if you just present enough data then people will get it. If you are that analyst then you are not going like this: but when you make a presentation you’re telling a story. The analysis does not speak for itself. You have to speak for it. While you want to show data, your audience is longing for insight. You want to chart every line in your model, your audience wants to understand what decisions they need to take.

And while we are on the subject of charts:1. Label your axes2. Avoid chart junk3. Use the appropriate chart for the type of data you are presenting. If you don’t know how to action points 2 or 3, Stephen Few will teach you4. Avoid pie charts. Always.

B.L.U.f Bottom Line Up Front. Lead with your conclusions. If the purpose of your presentation is to ask for an investment of $1.5 billion dollars in your infrastructure project, start with that.

Say “The purpose of my presentation is to ask for $1.5 billion to invest in Project X. We are going to talk you through the rationale for the project and we are then going to look at the key risks, and how we are going to manage those risks.”

In college you’re told to end with your conclusions. In business you have to start with them. Don’t talk for 20 minutes keeping people guessing about what it is that you actually want them to do.

doN’t BLUff The only acceptable answer to a question you do not know the answer to is “I don’t know the answer to that question.” No matter how slick you think you are, your audience can smell your bluff a mile off. They will then apply a bluff discount factor to everything that comes out of your mouth from that point onwards. Conversely, if you do not know, and you are honest about it, it builds trust. Unless you do not know the answer to any of the questions they ask, in which case you should not be making the presentation in the first place.

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rEcogNISE optIMISM BIAS

Your audience want reassurance that you understand the risks of the business venture you are modelling. Always telling them that everything is going to be OK is not going to cut it. Your infectious enthusiasm for the sector is going to make your presentation more enjoyable (see the final point), but it is not going to persuade anybody to part with $1.5 billion unless they know that you know where the risks lie and how you are going to manage them.

doN’t rEAd froM YoUr SLIdES

It is a slow and painful death for your audience. If the presentation is worth doing, it is worth doing properly. Learn your material. Or do not turn up.

pUt SoME LIfE INto It Do not phone in your performance. Get out in front of your audience. Use a remote slide clicker - they cost a few dollars. Make eye contact with every single person in your audience, in turn, and keep on doing it. Vary your voice. When you are making a presentation, you control the energy in the room. If you are not putting energy into the room, you are taking it out. Choose.

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chEck oUt oUr othEr EBookS...

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COPYRIGHTThis ebook is licensed under a Creative Commons Attribution-NoDerivs 3.0 Unported License.You are actively encouraged to copy, distribute and share this ebook provided that you provide proper attribution.

ESSENTIAL MODEL OPTIMISATION

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F1F9 builds and maintains financial models used by leading corporates, advisors, banks and funds.

We also train our clients to build better models themselves through courses delivered worldwide.

To discuss how our team can help you improve your corporate modelling and forecasting call John Dimberline on +44 1225 290525 or email john.dimberline@f1f9.com.

+44 20 3883 3425 www.f1f9.com

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