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The Physics of FP&A

By Karl Kern, Founder/President, Kern Analytics LLC

The Physics of Wall Street by James Owen Weatherall is an interesting story about the influence of physics in finance.  FP&A practitioners can find material in this book to help them improve their work.  For me three areas of the book serve as meaningful reference material.

The first area of the book that serves as meaningful reference material is a chapter dedicated to Benoit Mandelbrot.  Even though Benoit Mandelbrot was a mathematician rather than a physicist the book dedicated a chapter to his work studying coastlines and cotton prices which provides meaningful reference material about alternatives to statistical concepts like the Bell curve.  

The second area of the book that serves as a meaningful reference is a chapter dedicated to The Prediction Company.  The work of this company provides meaningful reference material about the study of patterns that may appear chaotic but at some level contain a pattern that can predict outcomes.  

The third area of the book that serves as meaningful reference material is a chapter dedicated to Didier Sornette.  Didier Sornette is a physicist who identifies situations that lead to significant effects, positive and negative, on wealth.  It is Didier Sornette’s work that is most appealing to me as an FP&A practitioner.

Financial planning is thinking about how an organization earns revenues, incurs expenses, and generates cash flows.  The most challenging part of this process is determining how revenues will move.  One determination is revenues will move forward through a steady growth rate, e.g. an increase of 10% per year over a 5 year period.  What the work of Didier Sornette presents is a way to think about movement.  Perhaps the revenue is based on a product that has characteristics of a fad.  If a product has these characteristics, the movement will not be at a steady rate.  As a result, thinking should be engaged on qualitative elements.  Active engagement into the qualitative elements of a product or service can determine whether the financial plan is based on a product or service that may be the next big thing.

Financial analysis is learning about how an organization earn revenues, incurs expenses, and generates cash flows.  What the work of Didier Sornette presents is a way to think about risk.  People think about risk as the probability of financial loss but people should think about risk as an exposure to danger.  During the growth of dot.com companies, telecommunication companies like Lucent had a customer base filled with these companies.  After the collapse of these companies, Lucent and others like them face financial challenges.  Perhaps learning about the types of customers can lead to learning about the risk that they have.  The risk that they have is a financial problem in the form of revenue declines; a financial problem like this is parallel to the work of Didier Sornette in non-financial areas described in the book such as Kevlar and earthquakes.

An important quality of FP&A practitioners is a commitment to continuous improvement.  A commitment to continuous improvement is through applying ideas from reference material.  The Physics of Wall Street is an example of reference material that can stimulate ideas for FP&A practitioners to make a commitment to continuous improvement.