MIM, the Materiality-Inconsistency Matrix, is all about prioritizing items from financial statements that can warrant additional information and insights.
This is extremely critical when a massive amount of information available and limited time given. No one has that luxury, or necessity in the real world!
What are Materiality and Inconsistency Matrix
It does matter where to begin, as all material but not all factors are to be examined or at least considered that affect a borrower’s future ability to repay (default risks/PD) its financial obligations in full, on time and without fuss. Fortunately, MIM can guide us through the very first step.
What is Materiality? It means the number is material, or comparable, to our golden reference point – equity buffer (link). No analysts will care if Apple Inc. ever decided to purchase a few additional laptops for some employees and might cause Apple to default – Immaterial items have minimal impact on a company’s financial performance.
But materiality itself does not tell the whole story. For example, a real estate company’s asset consists mostly of properties, and usually, that is material to its equity buffer. If the value of properties growing steadily and healthy, nobody would be picky about that. Only when you see the number suddenly “not within expectation”, for example, dropped by 80% while the market is booming, that item should then be highly prioritized to look at. That is inconsistent.
Inconsistency also has a reference point – normal business expectations. Those expectations could be derived from “internal information available about the company”, like management reports, business model & geographical information, etc.; or “external information” including market conditions, common practices to the industry, etc.
This is not as quantitative as equity buffer and is exactly why banks pay chunks of money to hire experienced bankers for their knowledge database. We all need to learn from real business cases and equip ourselves.
Let’s see how we can apply the MIM matrix into our real life.
How to use MIM with example
After we examine the financials and labeled data by “Materiality” and “Inconsistency”, we can further organize it into one prioritization matrix, shown below.
1. “Material and Inconsistent” – Warning Bell Quadrant
These items are of top priority to investigate; if not, you will be penny-wise, pound-foolish. For example, if a company has a high amount due to relative parties, like $5M compare to equity buffer of $6M –that could be a capital leakage.
2. Material but consistent – Red Flag Quadrant
Red Flag means it’s not at 100% safe zone and has the potential to be troublesome. You should not just happily accept them and ignore, but to examine it.
3. Immaterial but inconsistent – Red Flag Quadrant
If time allows, please also spend time dig into this. “Details make a difference”, we know from experience that is exactly those items can reveal underlying stories.
4. Immaterial and consistent – Green Quadrant
Avoid spending time on these items at all costs.
Above is a real-life example to use MIM. Ultimately, we can reveal most of the company’s stories and get close to the business truth by using MIM to analyze the financial statements.
Warren Buffet story and the 5/25 Rule
Interestingly that is also true to our day-to-day life.
The story goes that Buffett one day approaches his pilot, Mike Flint, after realizing that Flint had worked for him for the past 10 years. He wants to discuss Flint’s career goals and how he can help him achieve them. “The fact that you’re still working for me”, Buffett jokes, “tells me I’m not doing my job.”
To map out his goals, Flint was asked by his employer to conduct a simple exercise. It would change the way he viewed his priorities forever.
The first step in this exercise was to list down 25 things that Flint wanted to accomplish in the foreseeable future. Nothing was off the table.
Secondly, Flint was to Crank these items in order of importance and circle the top five. Prioritizing his goals was more undoubtedly challenging than listing them, but Flint managed it.
Just when it appears as though the most challenging part of the exercise was over, Buffett asks Flint a seemingly simple question: “what are you going to do with the remaining 20 items?”
“Well the top five are my primary focus but the other twenty come in at a close second”, Flint explained. He goes on, “They are still important, so I’ll work on those intermittently as I see fit as I’m getting through my top five. They are not as urgent, but I still plan to give them dedicated effort.”
At this point, Buffett’s expression changes a little. He responds sternly:
“No. You’ve got it wrong. Everything you didn’t circle just became your Avoid-At-All-Cost list. No matter what, these things get no attention to you until you’ve succeeded with your top 5.”