In finance, it’s often meekly agreed upon that everyone is right. “Well yes, of course, circumstance dependent, both approaches would be just as good” and conflict is avoided. I find this conciliatory attitude often wrong and always boring. Many times there is a right, or at least superior approach. For instance, earnings yield is better than P/E, just as Cadbury’s chocolate is superior to Hershey’s—both are simple facts.
But sometimes even a curmudgeon such as myself must admit that there isn’t a superior approach, just pros and cons depending on use case.
An example of this are the different styles of financial modeling. I usually opt for the positive-negative style, where inflows are positive and outflows are negative, compared to the positive-positive style where every number is positive in its expected direction.
But both ways have their positives and negatives.
Positive-positive is best used when calculating known events and it’s implicit what the number means by the context. In the case of gross interest, for example, you instinctively know that this is an amount the firm paid out and therefore has to be deducted, not added, in calculations.
When it isn’t clear if something is an income or an expense and you need context carried with the number itself, positive-negative makes more sense. It's carried context also makes it easier to just tot things up and arrive at a total without having to figure out what needs to be added and what needs to be subtracted.
So if these are the pros of positive-negative modeling, what are the cons? (I did say earlier that this was one of the occasions when there is no clear superior approach).
As financial filings use positive-positive style, to switch over to positive-negative is going against the grain and means being either inconsistent or having to change balance sheet liabilities to negative numbers1: and confuse everyone. Additionally, many ratio calculations require a minus sign in them, which is irksome.
As the complexity of the model grows, for examples debt schedules, cash flow waterfalls, or Monte-Carlo simulations (or all of them if you’re really enjoying yourself), the more important it is that the numbers carry their context with them and the harder it becomes to use a positive-positive style.
So in short, if you’re summarising historical data and working on something where context is obvious, positive-positive is the better modeling approach. For tackling unknown situations where you need the numbers to carry extra information about what they mean, it’s positive-negative for the win.
Being even-handed and reasonable is exhausting. I’m going to sit down and have a cup of tea.
Have a financial modelling question? Want an opinion about financial analysis? Email me at firstname.lastname@example.org.
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