Sunday, February 26, 2012

Find Your Denominator

What is finance? I'm glad you asked. Having passed an online course, I'm now an expert. Finance is about comparing investments so that you can make decisions about what to invest in. A dollar today is worth more than a dollar tomorrow, because it could be invested today (this is called the 'time value of money.') The problem finance tries to answer is: exactly how much is a dollar tomorrow worth today? The answer: lots of series and ratios.
discounted cash flow formula
The answer?
Really, this answer isn't so clear. It may appear to the layman that finance is just applied math, in which you can plug in a formula and get the right answer. But if this were the case, no one could make money, because everyone would have perfect information. (In this way, finance is predicated on rejecting the fundamental assumption of classical economics.) The math quickly falls away, either because few variables are certain or because there are many ways to calculate present value, depending on what assumptions you make.

What are you left with? Judgment, just like any other field worthy of intellectual pursuit. If finance could have been automated by computers, it would have been by now (never mind High Frequency Trading). Becoming good at finance is a matter of knowing which formula to apply when, or how to prioritize which evaluations. This involves experience and general principles, not rules. If you didn't like word problems as a student, don't go into finance.

good to great by jim collins
Not bad
Jim Collins makes this point in his book Good to Great. He argues that since gross profit comparisons in themselves are not very useful, companies need to discover their particular ratio that slices through the numbers. For an architecture firm, this might be profit / design. For an eCommerce site, it could be profit / transaction. For a real estate agent, it may be profit / time on the market. You have to find your economic denominator. These are not formulas they teach in business school, and they are not always obvious.

For IT professionals, all this suggests that the people in suits might not know what they want to see. This has nothing to do with the typical IT complaint that business users don't know what they want, because they don't understand the technology. Rather, there is an element of uncertainty at the heart of financial planning that has nothing to do with technology. Key Performance Indicators are not given and they will change as a business and its economic climate changes.

This uncertainty is a boon for IT people because, sometimes, knowing enough to be dangerous about something allows you to think more creatively than those indoctrinated by a professional education. Get data on everything. Enable users to compare crazy things. Make a tool that charts profit per every single metric you have available. Some might not make any sense, but some might just be the KPI your business has been looking for. Even if you're not a licensed data scientist, you can play the part.

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