Financial models are a key element in most major business decisions

Importance of Financial Modeling

Financial models are a key element in most major business decisions. A financial model is prepared whenever any organisation is considering project finance, bidding for a project, evaluating acquisition target, carrying out monthly financial planning, conducting capital structure studies, etc.

They are useful tools that allow business options and risks to be evaluated in a cost-effective manner against a range of assumptions, identify optimal solutions in evaluating financial returns and understand the impact of resource constraints to make the most effective business decisions.

Indian companies are becoming increasingly integrated with the global economy by establishing/acquiring operations overseas, increasing the export/import intensity of their businesses, entering into global alliance, raising funds from overseas market, etc. Even within India, companies can no longer afford to assume fixed capacity and a ready market scenario.

In view of these factors, they require robust financial models which can help them in carrying out the analysis of the complexities of each country on their operations, consider multiple currencies in their models, evaluate varying capacity as well as capacity utilisations to find out the optimal capacity under varying industry demand-supply scenarios and similar other cases.

In India, organisations do not often have the necessary skill sets in conceptualising and developing modelling solutions that can facilitate an accurate evaluation of critical complex business decisions. Their financial models are often not based on best practices (as described later) and a comprehensive, independent review of the financial model by experts is seldom done. A best practice model is:

easy to understand — by using a transparent design;

reliable — by using control checks so that an error is automatically flashed;

easy to use — so that one can be more productive in using the model for analysis rather than struggling just to produce simple results from a badly designed model;

focussed on the important issues — so that one does not waste too much time in development of immaterial items;

These benefits can be achieved by using the generally accepted principles and techniques while developing a financial model.

Financial modelling is an art and like any other form of art, one needs constant practice and commitment to develop expertise in this area.

(The authors are Assistant Vice-President and Senior Associate, respectively, Ernst & Young.)

If you want to know learn Financial Modeling then you can go for NCFM Certification in Financial Modeling, at http://proschool.imsindia.com or www.nseindia.com, This is the one of the only program in India which give you right training and practical orinented content to prepare robust Financial Models.

The Importance of Financial Modeling
The Global Explorer, 2008 Fall Issue

How to Make Your Foray Into Global Markets a Successful One

Perhaps the biggest mistake organizations make regarding their global strategies is failing to change those strategies in the wake of changing conditions. For example, a Mexico strategy developed in the wake of NAFTA or a China strategy developed after its acceptance to the WTO may no longer be sound. These companies must ask themselves, “Does it still make sense to do business in Mexico? In China? And if not, then where?”

The objective of a financial model is to position clients for success in their foreign investments. What’s the cost of doing business in a given country? What’s the breakeven point? When might you exceed the profitability of a similar operation in the United States?

Answering these questions isn’t as easy as it seems. A variety of factors come into play, from the raw material costs, transportation costs, and salaries to energy costs, environmental concerns, and taxes. All of these factors fluctuate, which is why an effective financial model is so crucial.

Raw Material & Transportation Costs

At the moment, there’s not a significant difference in the cost of raw materials based on location. The biggest factor is how close you are to your source. Why? Because of ever-escalating transportation costs, driven by the increase in the cost of fuel.

It’s hard to believe that back in 2000, oil prices were around $25/barrel. Today, it tops out at $150/barrel, which means to ship by land from central Mexico to the northern United States, you could be looking at $3,200/40-foot container (versus $1,800 in the good old days). When it comes to shipping (via ocean) from China to the U.S. eastern seaboard, fuel costs have tripled since 2000.

This is quite a wake-up call for those organizations that went to China because of differences in labor costs, only to find those savings negligible in the wake of rising fuel and transportation costs. Bottom line: if you’re thinking of setting up an operation in China to ship product to the U.S., you may want to rethink your strategy. If you’re thinking of distributing items within an international market, you may fare better. However, be advised that your investment will have to be approved by the Chinese government, which tends not to support manufacturing for local consumption as readily as they do for export.


Salaries

“Low cost countries” have historically been known as such largely due to cheap labor costs. Today, however, labor costs are going up across the board. China is experiencing increases of 8–12 percent/year, and India is experiencing increase of 6–8 percent/year. Today, the average labor cost for unskilled labor in China has more than doubled what it was a mere eight years ago.

Moreover, it’s becoming increasingly difficult to attract and retain skilled labor in these countries. In China, management tends to be between 35 and 40 years old, and people don’t tend to stay in one place for long. Thanks to the ability to procure pay increases in the 40–50 percent range, junior management turns over every two years or so, whereas senior management turns over about every four years. It’s important to take this into consideration when planning a global strategy.

Energy Costs & Environmental Concerns

Energy costs also continue to rise, largely due to the cost of fuel and the demand for it. Both developed nations and emerging markets have an increasing demand for energy. And then there are the environmental concerns. During the recent Beijing Olympics, the government closed down all factories, stopped almost all construction, and removed 2 million vehicles from the roads for a two-month period to increase the quality of air for the games.

In addition, the Chinese government may restrict the amount of electricity companies can use. We’ve recently met with various local governmental officials to make sure one of our clients’ projects will get approved because of restrictions on the electricity levels that client can use.

Taxes

Taxes are an enormous consideration, especially in China. In the past, China offered tax holidays to attract businesses; unfortunately, those holidays are no more. Today, all businesses but those in encouraged industries such as high-tech pay the local China tax of 25 percent. (High tech companies get a break at 15 percent.)

For Mexico, the income tax rate is 28 percent. Although the income tax rate itself has decreased with the introduction of the IETU flat tax, most companies actually find themselves paying more taxes than before. In general, it’s important to keep taxes in mind when evaluating a global strategy.

A Financial Model Can Help

We’ve seen several companies go to foreign countries without doing a financial model or understanding the numerous considerations inherent in doing business globally. They tend to think the circumstances will be the same as in the United States; in truth, things couldn’t be more different.

That’s why financial modeling is so critical. However, there’s no one-size-fits-all model; your particular model would take into account the type of business you have, the products you sell, and who you compete with, among other things. It should also consider a variety of “what if” scenarios, like “What if transportation costs go from $100 to $200?” or “What if you only make $5 million in sales versus the $15 million you thought you’d make?”

They key is flexibility and understanding the effects that even incremental change can have on the success of a global strategy. The impact of unexpected change on resources, cash, and management can be severe.

For companies considering their global options, a financial model is an effective way to illuminate their best options and eliminate potentially costly mistakes. Moreover, even if an organization develops its own financial model, don’t underestimate the importance of having an experienced firm like Plante & Moran Global Services review it and offer comments based on our experience in global markets.

Frankly, it’s an investment most companies can’t afford not to make.

Plante Moran Global Services helps clients explore their international options and expand their businesses globally. With offices in Chicago, Detroit, China, and Mexico, the Plante Moran Global Services team of engineers, consultants, and CPAs has helped dozens of clients of all sizes to assess their international options in a way that optimizes their chances for success

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