How is a financial model like bagpipe music? It may sound like a trick question (or a joke about inducing headaches) but it’s actually one I often use when opening a training session for budding financial modellers.

I start by showing the following image:

and invite them to tell me what it tells them.

Most people recognise that is sheet music. Very, very few are able to identify the tune as ‘Scotland the Brave’. No one realises that this score is specifically written for the Great Highland Bagpipes.

People have to take it on trust from me – using my experience as a piper – that this notation is correct. The time signature is in order, the grace notes are appropriate and there are no errors in the markings. This music was produced in standard settings.

But regardless of how strictly this sheet adheres to best practice, it’s not terribly useful to most of the audience without having someone to explain it, or a musician to play it. This lesson has a strong parallel when it comes to financial models. We don’t have to go back far in history to find an example of where this actually happened.

West Coast rail faces the music

In 2012 Virgin raised concerns about the outcome of its bid to retain the franchise to operate the West Coast Main Line, the principal rail route linking London, Manchester and Glasgow.

Lacking time to develop an analysis that could perform one part of the appraisal, the Department for Transport pressed into service an existing model used for a different purpose.  That model may well have been perfect in its original application, but, auditors from Ernst & Young found, its users had misunderstood its role in the new context and misinterpreted its results.  Inflation and elasticity, which had significant effects on the risk capital assessments, were either ignored or applied inconsistently to the bid submissions.

The DfT cancelled the decision to award the contract to the First Group, and the consequences of this confusion included:

  • the £2.7m cost of the enquiry;
  • £45.8m of compensation being paid by the DfT to the four companies which had submitted bids;
  • a four year delay to the orderly process for renewing the franchises of all of the other lines in the UK;
  • up to £100m in opportunity costs from postponing the day when competitive pressure on bidders would drive them to greater efficiencies and bring substantial savings to the government and to passengers.

Practice alone doesn’t make perfect

There are a plethora of measures to help ensure that models are produced to a high standard. There is any number of proprietary model development methodologies promoted by particular companies offering to reassure senior executives that there is one right way to build financial models. But these assurances aren’t terribly useful when you can’t interpret what you are looking at, or make sound business decisions with the information to hand.

In other fields of business, at times you need to call in the professionals. Three-hundred page contracts demand review by the lawyers. Accountants are vital for inspecting company books or giving assurances in M&A deals. Complicated project finance modelling requires interpretation by modelling specialists. In music and financial models both, a lack of understanding or interpretation leaves you with one thing: discord.

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