Why a best-practice financial model is an important corporate governance tool

There are many elements that form a company’s corporate governance structure. The Cadbury Committee (1992) in the UK defined corporate governance as “the system by which companies are directed and controlled”. Clearly a best-practice financial model forms the basis of executive management decision making and future direction of the company, through the leveraging of value-adding tools such as the strategic plan, sensitivity and scenario analysis. The disciplined monthly or periodic reporting of the company’s financial statements helps executive management to control and monitor the financial performance of the company.

How a model helps to better direct a company

There are many instances when a best-practice financial model assists in the direction of a company. The strategic planning process helps a corporation to better conceptualise and quantify its future direction. By outlining forecasted rates of growth, under various growth scenarios, the strategic plan will force executives to be more accountable for all of their decision-making and understand how these decisions will impact the corporation’s future financial performance.

On a more micro level, a commercial pricing model, which is used to price a new good or service, based on a determined unit price, expected direct costs and partial allocation of indirect costs (under the auspices of activity-based costing) represents another corporate governance tool. By requiring executive management to use a uniform template to price a new good or service, it controls or directs the minimum rate of return a corporation will allow for a future good or service sold.

A further corporate governance feature of this pricing model is the version control with the “Full” version restricted to executives like the Controller and CFO, for the purposes of the arbitrary allocation of indirect costs, incremental versus full costing and analysing the cash flow of the commercial arrangement. Whilst the “Light” version is the domain of employees and middle management, who have more operational knowledge and will concern themselves only on the return on sales and profit margin.

A best-practice financial model will feature comprehensive error and alert checks throughout, which will help to safeguard the overall accuracy of the model. This reinforces and bullet-proofs the financial model, and enables executives to safely rely on it as a corporate governance tool, and to better manage the company’s future financial direction.

Controlling the management of a company

Equally as important is the importance of corporate controls, which a best-practice financial model delivers via a customised, audit-friendly and robust monthly reporting tool. This model provides a transparent, consistent and user‐friendly repository for executive management to analyse, and compare monthly and actual financials relative to budget or forecast.

If the company is trailing forecasted or budgeted earnings, then the efficient and accurate best-practice monthly financial model will clearly communicate this to executives. Hence they will be able to make the necessary business decisions, i.e. improve sales or manage costs, in order to help control the company’s expected financial performance. This represents one of the key tenets of a corporate governance tool.

As discussed, the implementation of error and alert checks throughout the best practice financial model, will not only verify the source financial information from a system like Hyperion or Simply Accounting, but will also check financial metrics that were used to report, forecast and analyse the financial performance of the company.

How a model can both direct and control a company

On the surface, a best-practice financial model’s sensitivity and scenario analyses represents a valuable corporate governance function, as they can both influence executive direction and control of the company.

A sensitivity analysis such as measuring the impact of a 15% increase in gas prices on a logistics company’s earnings, or a training company reducing its unit course price by 10% and forecasting a 8% increase in unit enrolment volumes (refer to the following presentation), are examples of a model’s ability to assist executives to control the company’s financial performance.

Whereas a scenario analysis outlining the impact of financial performance, for example the divestment of an inefficient and poorly performing business unit, or a Greenfields capex expansion into a new product sub-range, will help to direct and guide executives with future decision-making.

A best-practice financial model and its role in corporate governance for Your Company

The introduction of a disciplined, best-practice financial modelling regime in a corporation delivers added-value in many ways. Similar to its importance to drive lean finance throughout a firm, a model’s role in the implementation of corporate governance systems is equally paramount.

As the Cadbury report in Britain stated, corporate governance are tools to direct and control a corporation. As discussed, a best-practice financial model helps to control a corporation via disciplined periodic reporting, and implementation of strategic plans or commercial pricing models to assist in the future direction of the company.

Further, the addition of scenario and sensitivity analyses will further safeguard how the company’s executive management direct, control and properly plan its financial future.