Evolving FP&A: Why Prediction Is Important

Evolving FP&A: Why Prediction Is Important

By Karl Kern, Founder/President, Kern Analytics LLC

predictionAs an FP&A practitioner, I am called upon to make predictions on behalf of clients. Two of the more prominent predictions I am asked to make are Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA) and cash flows.  I am asked to make these predictions in order to determine valuations and financing requirements.     

Prediction Entities       

What I describe above is precise in that it focuses on a specific type of entity, startups.  Startups, however, are not the only entities that require predictions.  Small businesses require predictions in order to determine the timing of cash flows for paying employees and vendors.  Middle market companies require predictions in order to compete against smaller, more agile businesses or larger, wealthier businesses.  Large businesses require predictions in order to exploit potential growth opportunities. 

Businesses are not the only entities that rely on predictions; we as individuals rely on predictions to conduct tasks like going to work, meeting with friends, or dealing with adverse weather conditions.  These examples serve as reasons for why prediction is important however I found other reasons that give it credence in our work as FP&A practitioners.

We Tend not to Take Prediction Seriously...

I found the other reasons in a book written by Nate Silver titled The Signal and the Noise.  Nate Silver gained prominence in his work on predictions during the 2008 and 2012 presidential elections in the United States.  His book addresses not only elections but topics like finance, sports, and weather.  What may seem funny is the other reasons that I’m about the present do not come from the chapters in the book but praise for the book by Bill James; Bill James is most known for his work in transforming the way Major League Baseball games are played through his work with statistics.  In his praise of the book, Bill James made two statements that I find relevant to the importance of prediction.  The first statement is “Projection, prediction, assumption, trepidation, anticipation, expectation, estimation…we wouldn’t have eighty words like this in the English language if it wasn’t central to our lives.”  The second statement is “We tend not to take prediction seriously because, on some level, we know that we don’t know.”

The Uncertainty is Real

Why do I consider Bill James’ statements so important?  When we consider the first statement I previously provided a number of examples that support the importance of prediction but there’s one example that makes our work as FP&A practitioners vital.  Our work focuses on creating insights into the strengths and weaknesses of the financial health within businesses and without these insights businesses will fail and stakeholders like employees and communities will suffer.  When we consider the second statement we as FP&A practitioners must acknowledge that uncertainty is real.  We must acknowledge that we don’t know for certain whether one customer or several customers will stay in business and that can mean sales predictions could turn for the worse.  We must acknowledge that we don’t know for certain whether a service provider may institute price increases which can turn expense predictions awry or a supplier may discontinue shipments which can cause a ripple effect among production and selling functions.  Bill James’ statements give us some food for thought: people want to know what tomorrow will look like but no matter how hard we try giving people a precise tomorrow is impossible.

Making predictions is an important part of our work as FP&A practitioners.  Its importance is due to need but need can be hindered due to incomplete knowledge. Our work, therefore, must focus on maximizing the positive and minimizing the negative about prediction.