"The map is not the territory" - Alfred Korzybski.
People often confuse models of reality with reality itself. Models represent things, but they are not identical to those things.
This is true of financial models.
A financial model is an abstract representation of a business. The job of the model is to help us answer important questions about the business.
- "When will the business run out of cash?"
- "How much can the business borrow?"
- "What is the business worth?"
Now for an important distinction.
The complexity of the business, and the complexity of the model, are two different things.
Just because the business is complex, it does not mean that we have to build complexity into our model. The simpler our model, the more valuable it will be in helping us understand the business complexity.
If we build a complex, hard to understand model, it cannot do its job of helping us to understand the business better.
I have heard modellers say that a simple approach won’t work because they are modelling something very complex. This is a mistaken view sometimes an excuse for sloppy, over-complicated modelling.
Model complexity compounds business complexity.
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