The practicalities of operating a project company
Excel models need updating, management accounts need to be mapped into the models, the directors and shareholders ask questions about indexation, life cycle expenditure changes, working capital needs to be understood, VAT can cause havoc to the cash flows, and of course the banks require compliant cover ratios to allow distributions to the shareholders.
Balancing the interests of the shareholders and lenders
The lender is the cat that guards the cash and the shareholders are the mice that need small pieces of the cash to survive. Both parties are necessary to begin with and it is also necessary that they can subsequently live with each other.
Reinvention of modelling methods
In every project company, in every bank and at every consultancy there are young modellers reinventing modelling for the umpteenth time. This is risky and unnecessary. Thanks to PFI and the large number of projects in operation there have been some distinct modelling advances in recent times. This book outlines these advances.
What accountants can and cannot do
There is a feeling amongst some project company directors that the management accountants should be able to build and run a financial model to satisfy the banks and reporting process, but I do not think this is the case.
The banks require the model used by the project to be audited. While this is a financial check it is also a logical and technical review. The project company’s need for a model audit and the specification of the model audit highlights the fact that models are essentially logical machines with lots of interconnections set within a wider context of fairly straightforward finance.
Logical machines work best when built by expert builders of logic. I believe these expert builders of logic are engineers and mathematicians with knowledge of finance.
Human error
In addition to these difficulties already mentioned, it is also important to recognise another major problem in modelling, which is that financial models tend to be managed by a single person. While this is best practice in terms of focused organisation it is also highly risky in terms of possible human error. Errors in spreadsheets are a well-reported phenomenon and here are some possible reasons why:
lack of time to double-check analysis
models create a bottleneck during analysis where only one person can perform the work – this is due to the possibility of important logical changes that need to occur in a single file
only one person understands the complexities in a model
managers have no detailed insight into the model logic
the risk of human error, especially for the lone modeller, is high
lack of good channels of communication.
This problem of spreadsheet risk is very real and permeates a wide variety of very large companies and industries.
The problem outlined here is thus financial, technical and human so the modelling solution should confront these same issues.
The modelling solution
Different approaches in the modelling market
There are different approaches in the modelling market, varying from the excessively light to the excessively heavy solution. The light approach delivers a skeletal starting model where substantial addition and maintenance may be required over time to satisfy the long-term commercial objectives.
The heavy approach delivers large models with unnecessary duplicate logic, effectively creating a greater need for maintenance, a lack of clarity and higher risk.
The right approach provides the commercially required logical content from the start with the clear understanding that maintenance will always be required.
The right approach
The right approach to modelling is a holistic one taking into account all of the issues surrounding the modelling problem – financial, technical and human – and not just some of the financial and technical ones.
The approach I propose in this book covers the following areas:
Financial & legal – dealing with the theoretical financial, commercial and legal issues, and solutions:
the project characteristics and legal entities involved
the industry characteristics
the macro economy
the government
strategic or operating solutions
seeding the future with the past
the relative importance of cash and accounting.
Technical:
using Excel
using a computer
using other software (the minimum required).
Human:
managing the build
managing model control
managing model delivery
checking the model for errors.
This approach is illustrated in Figure 1.
Figure 1: The holistic modelling solution of See-Through Modelling
Lessons learnt from PFI
Use of Microsoft Excel for financial modelling
Microsoft Excel has become the tool of choice for financial and business modelling, and the UK PFI has gone a long way to prove this. The 900 or so UK PFI projects have required meticulous planning, reporting and human interchange, and this has all been done in Microsoft Excel. This is not withstanding the availability of many other software solutions.
As with most solutions Excel has its strengths and its weaknesses. First the strengths:
Flexibility – Excel is a simple grid across as many sheets as the user needs with the power to add formulae in multiple cells.
Grid
