Why Do We Need a Strategic Company Model Instead of the One Showing Financial Results?

Financial Planning and Analysis (FP&A) is a vast area of practice that a corporation utilises. Strategic Planning stands out among the other FP&A-related tasks due to its long-term and often irreversible impact on a corporation's future.

The main challenge of making a strategic decision is the sheer complexity of the possible outcomes. There are many moving parts, so the longer the planning horizon and the more time- or path-dependent of the moving parts, the more complex the decision can be.

Corporate managers today are dazzled by a sea of analytical, forecasting, and planning tools. However, strategic planners need to step back and think hard about the technology. In my view, the importance of a business model underpinning strategic decision-making has been underemphasised. Furthermore, strategic planners should not mistake a more significant number of variables included in a tool with a better understanding of complexity.

Many tools, particularly Artificial Intelligence (AI)/Machine Learning (ML), can help us handle the large number of variables considered, including alternative data or big data. However, the complexity encountered in corporate planning does not arise from the number of variables but from their interdependence. The key variables that finance professionals should consider are those included in the balance sheet and the income statement. While there are many of them, they don't exist in millions, as boasted by different AI/ML tools. However, the complexity lies in the combinations of these variables, the number of which usually exceeds the number of variables. Given N variables, the number of possible pairs is ~N², and all possible combinations are ~2^N.

How can we untangle this complexity effectively? The key is to specify the interdependence of the financial variables. This is similar to the physical systems, which are modelled using partially different equations, serving to specify how various variables are related to one another. How do we achieve this goal in financial modelling? Clearly, the traditional 3-statement-based financial models are inadequate. In my approach, the answer lies in the one entity that connects all the variables. It is the company itself.

The Essentials of a Strategic Model

A company-centric model must encompass four key company attributes: anatomy, actions, goals, and uncertainty.

• Anatomy

Much like the bone structure of a human, a company's anatomy contains the key elements of a business and, more importantly, the fixed relationships among the organisation's financial and operational variables. These fixed relationships are like the anatomical restrictions of a company's movements. They include financial accounting rules and industry-specific constraints such as the processing capacity of a facility or the processing time and inputs of the company's products.

• Actions

Any business is a living entity because it acts. A company model defines the collection of actions a company engages in, similar to the repertoire of a video game fighting character's moves. No matter how complex, an enterprise's actions are made up of basic elements that all businesses share – buy and sell inventory, borrow and pay a debt, etc. Each of these elementary actions changes a company's financial state in a specific way, and they serve the same role as differential equations in scientific models.

• Goals

A company's actions are different from mechanical movements since they are goal-oriented and made to achieve specific financial results. Even if a company's goals are relatively fixed, the actions required to complete a particular aim should change when conditions alternate. This means that the strategic model must be able to compute the most optimal course of action in response to changing external factors, given a set of goals.

• Uncertainty

Although a company may plan its actions, its outcome remains uncertain due to the uncontrollable reaction of the action's counterparty. For instance, a company may always want to sell 100% of its inventory, but the customers most likely will accept less than that. Strategic Planning must identify the key sources of uncertainty within a company's operations.

Implementing a Company Model for Strategic Planning

At its core, Strategic Planning is deciding on an action, or a course of actions, given a set of goals by evaluating the action's long-term and irreversible consequences. An action-based company model naturally fits into this objective. Decision-makers can operate it with a clear view of the consequences of the actions if they unfold in the future.

• Implementing a Company Model

The complexity of such a model may deem its practical implementation doubtful. However, some systems are designed specifically for this purpose. Indeed, the numerical computation required in company models spans beyond the ability of Excel, and neither low-level programming language suits it. This model needs to be programmed in languages used for scientific computing or sophisticated animation software.

• Dealing with Forecasting Complexity

Action-based company models are generative. Complex actions are generated from compounding elementary activities; a single model may have more than 100 of them. Each elementary action changes a company's financial state in a simple and well-defined way. The anatomical restrictions on each elementary activity compound into more limitations on the outcome of complex actions, leading to the strong predictive power of the model.

• Applying the Company Model in Strategic Planning

To decide on a strategic action within a set of goals, the planner can specify the action in the model and use the Monte Carlo method to simulate the external uncertainties. The model-generated outcomes show how well a prescribed action achieves the intended goals, including the conditions under which the action performs well or poorly. A more robust approach would be to simply specify the goals in the model and let the model compute the most optimised action under the external uncertainties.

Conclusion

A company's strategic planner can be well served by building a model of the company itself. However, a business may need to consult an action-based modelling expert before starting.