# Stochastic Balance Simulation

This entry is part 1 of 6 in the series Balance simulation

### Introduction

Most companies have some sort of model describing the company’s operations. They are mostly used for budgeting, but in some cases also for forecasting cash flow and other important performance measures. Almost all are deterministic models based on a single values forecasts; the expected or average value of the input data; sales, cost, interest and currency rates etc. We know however that forecasts based on average values are on average wrong (Savage, 2002).  In addition deterministic models will miss the important dimension of uncertainty – that gives both the different risks facing the company and the opportunities they produce.

In contrast, a stochastic model will be calculated a large number of times with different values for the input variable drawn from all possible values of the individual variables. Each run will then give a probable realization of future cash flow or of the company’s equity value etc. With thousands of runs we can plot the relative frequencies of the calculated values:

and thus, we have succeeded in generating the probability distribution for the company’s equity value. In insurance this type of technique is often called Dynamic Financial Analysis (DFA) which actually is a fitting name.

### The Balance Simulation Model

The main tool in the S&R toolbox is the balance model. The starting point is the company’s balance, which is treated as the simulations opening balance. In the case of a greenfield project – new factories, power plants, airports, etc. built from scratch – the opening balance is empty.

The successive balances are then built from the Profit & Loss, by simulation of the company’s operation thru an EBITDA model mimicking the real life operations. Investments can be driven by demand (capacity calculations) or by investment programs giving the necessary or planned production capacity. The model will throughout the simulation raise debt (short and/or long term) or equity (domestic or foreign) according to the financial strategy set out by the company and the difference between cash outflow and inflow adjusted for the minimum cash level.

Since this is a dynamic model, it will raise equity when losses occur and/or the maximum Debt/equity ratio has been exceeded. On the other hand it will repay loans, pay dividend, repurchase shares or purchase excess marketable securities (cash above the need for the operations) – all in line with the board’s shareholder strategy.

### The ledger and Double-entry Bookkeeping

The activity described in the EBITDA model; investments, purchase of raw materials, production, payment of wages, income from sales, payment of special taxes on investments etc. is registered as transactions in the ledger, following a standard chart of accounts with double-entry bookkeeping. In a similar fashion are all financial transactions; loans repayments, cash, taxes paid and deferred, Agio and Disagio, etc. posted in the ledger. Currently, approximately 400 accounts are in use.

### The Trial Balance and the Financial Statements

The trial balance (Post-Closing) is compiled and checked for balance between total debts and total credits. The income statement is then prepared using revenue and expense accounts from the trial balance and the balance sheet is prepared from the asset and liability accounts by including net income with the other equity accounts – using the International Financial Reporting Standards (IFRS).

The general purpose of producing the trial balance is to ensure that the entries in the ledger are mathematically correct. Have in mind that every run in a simulation will produce a number of entries in the ledger and that they might differ not only in size but also in type depending on the realized states of the company’s operations (see above). We therefore need to be sure that the final financial statements – for every run – are correctly produced, since they will be the basis for all further financial analysis of the company.

There are of course other sources of errors in book keeping; compensating errors, errors of omission, errors of principle etc. but after many years of use – with millions of runs – we feel confident that the ledger and financial statements are produced correctly. The point is that serious problems need serious models.

However there are more benefits to be had from simulating the ledger and trial balance:

1. It increases the models transparency; the trial balance can be printed out and audited. Together with the models extensive reporting and error/consistency control, it is no longer a ‘black box’ to the user.
2. It makes it easy to plug inn new EBITDA models for other types of industry giving an automated check for consistency with the main balance simulation model.
3. It is used to ensure correct solving of all implicit equations in the model, the most obvious is of course the interest and bank balance equation (interest depends on the bank balance and the bank balance depends on the interest) but others like translation hedging and limits set by the company’s financial strategy, create large and complicated systems of simultaneous equations.
4. The trial balance changes from year to year are also used to ensure correct year to year balance transition.

### Financial Analysis, Financial Measures and Valuation

Given the framework described above financial analysis can be performed and the expected value, variability and probability distributions for the different types of ratios; profitability, liquidity, activity, debt and equity etc. can be calculated and given as graphs. All important measures are calculated at least twice from different starting points to ensure consistency and correct solving of implicit equations.

The following table shows the reconciliation of Economic Profit, initially calculated from (ROIC-WACC) multiplied with Invested capital:

The motivation for doing all these consistency controls – in all nearly one hundred – lies in previously experience from Cash Flow/ Valuation models written in Excel. The level of detail is more often than not so low that there is no way to establish if they are right or wrong.

More interesting than ratios, are the yearly distributions for EBITDA, EBIT, NOPLAT, Profit (loss) for the period, Free cash Flow, Economic profit, ROIC, Wacc, Debt and Equity and Equity value etc. giving a visual picture of the uncertainties and risks the company faces:

Financial analysis is the conversion of financial data into useful information for decision making. Therefore, virtually any use of financial statements or other financial data for some purpose is financial analysis and is the primary focus of accounting and finance. Financial analysis can be internal (e.g., decision analysis by a company using internal data to understand or improve management and operating results) or external (e.g., comprehensive analysis for the purposes of commercial lending, mergers and acquisition or investment activities). The key is how to analysis available data to make correct decisions.

### Input

As input the model needs parameter values and operational data. The parameter values fall in seven groups:

1. Parameters describing investors preferences; Market risk premium etc.
2. Parameters describing the company’s financial strategy; Leverage, Long/Short-term Debt ratio, Expected Foreign/ Domestic Debt Ratio, Economic Depreciation, Maximum Dividend Pay-out Ratio, Translation Hedging Strategy etc.
3. Parameters describing the economic regime under which it operates: Taxes, Depreciation Scheme etc.
4. Opening Balance etc.

Since the model have to produces stochastic forecasts of interest(s) and exchange rates it will need for every currency involved (included lower and upper 5% probability limit):

1. The Yield curves,
2. Expected yearly inflation
3. Depending on the forecast method(s) chosen for the exchange rates; the different currencies expected risk premiums or real exchange rates etc.

Since there is a large number of parameters they are usually read from an excel template but the program will if necessary ask for missing or report inconsistent values of the parameters.

The company’s operations are best described through an EBITDA model even if prices, costs and production coefficients and their variability can be read from an excel template. A dedicated EBITDA model will always give the opportunity to give a more detailed and in some cases complex description of the operations, include forecast and demand models, ‘exotic’ taxes, real options strategies etc., etc.

### Output

S@R has set out to create models that can give answers to both deterministic and stochastic questions the tables will answer most deterministic issues while graphs must be used to answer the risk and uncertainty related questions:

 Profit and loss Free cash flow valuation Balance sheet NPV and IRR analysis Foreign exchange rates effect Translation hedging Debt and equity calculations Added value reports Production, sales and inventories Current and deferred tax Contribution analysis Cash flow reports Operating and working capital Financing reports Ebit, Noplat and free cash flow Value drivers Economic Profit calculations Trial balances Economic profit valuation Closing balance changes Stakeholders report Etc.

1.    In all 27 different reports with more than 70 pages describing operations and the economics of operations.
2.    In addition the probability distributions for all input and output variables are produced.

### Use

By linking dedicated EBITDA models to holistic balance simulation, taking into account all important factors describing the company. The basis is a real balance simulation model – not a simple cash flow forecast model.

Both the deterministic and stochastic balance simulation can be set about in two different alternatives:
1.    by a using a EBITDA model to describe the companies operations or
2.    by using coefficients of fabrications (e.g. kg flour pr 1000 bread etc.) as direct input to the balance model.

The first approach implies setting up a dedicated EBITDA performance and uncertainty, but entails a higher degree of effort from both the company and S@R.

The use of coefficients of fabrications and their variations is a low effort (cost) alternative, using the internal accounting as basis. This will in many cases give a ‘good enough’ description of the company – its risks and opportunities: The data needed for the company’s economic environment (taxes, interest rates etc.) will be the same in both alternatives.

In some cases we have used both approaches for the same client, using the last approach for smaller daughter companies with production structures differing from the main companies.
The second approach can also be considered as an introduction and stepping stone to a more holistic EBITDA model.
What problems do we solve?

• The aim regardless of approach is to quantify not only the company’s single and aggregated risks, but also the potential, thus making the company capable to perform detailed planning and of executing earlier and more apt actions against risk factors.
• This will improve stability to budgets through higher insight in cost side risks and income-side potentials. This is achieved by an active budget-forecast process; the control-adjustment cycle will teach the company to better target realistic budgets – with better stability and increased company value as a result.
• Experience shows that the mere act of quantifying uncertainty throughout the company – and thru modeling – describe the interactions and their effects on profit, in itself over time reduces total risk and increases profitability.
• This is most clearly seen when effort is put into correctly evaluating strategies-projects and investments effects on the enterprise. The best way to do this is by comparing and choosing strategies by analyzing the individual strategies risks and potential – and select the alternative that is dominant (stochastic) given the company’s chosen risk-profile.
• Our aim is therefore to transform enterprise risk management from only safeguarding enterprise value to contribute to the increase and maximization of the firm’s value within the firm’s feasible set of possibilities.

Strategy@Risk takes advantage of a program language developed and used for financial risk simulation. We have used the program language for over 25years, and developed a series of simulation models for industry, banks and financial institutions.

The language has as one of its strengths, to be able to solve implicit equations in multiple dimensions. For the specific problems we seek to solve, this is a necessity that provides the necessary degrees of freedom to formulate the approach to problems.

The Strategy@Risk tools have highly advance properties:

• Using models written in dedicated financial simulation language (with code and data separated; see The risk of spreadsheet errors).
• Solving implicit systems of equations giving unique WACC calculated for every period ensuring that “Free Cash Flow” always equals “Economic Profit” value.
• Programs and models in “windows end-user” style.
• Extended test for consistency in input, calculations and results.
• Transparent reporting of assumptions and results.

### References

Savage, Sam L. “The Flaw of Averages”, Harvard Business Review, November 2002, pp. 20-21

Mukherjee, Mukherjee (2003). Financial Accounting. New York: Harper Perennial, ISBN 9780070581555.