The Value of Stress Testing Your Financial Plan
As we approach the end of the fiscal year and begin a new one, business leaders have an overriding concern: How accurate are the assumptions we made when we created our plan? This is especially concerning as we look ahead to another challenging year of economic uncertainty.
All plans, to a certain extent, are based on assumptions. You gather input from each department head, set goals, lay out steps for achieving those goals, and estimate expenses. Some assumptions are based on internal factors, which means you have direct control over them. As an organization, you can decide whether you want to hire more sales representatives, open a new regional office, or expand your product line. Other assumptions are based on external factors, which we all know have been and will continue to be in a constant state of flux – from rising interest rates, inflation, to the price of oil and gas, and so on. Obviously, you can’t control these factors, but you will need to know how any changes in them may affect your financial statements. This is where stress testing your financial plan comes in.
Stress testing helps you predict how change will impact your financial statements so you can adapt quickly. Additionally, CFOs are keen to improve the way they define their financial metrics as drivers of growth, and to put initiatives in place for the whole company to focus on those metrics. Stress testing helps this effort by allowing you to ‘test’ those metrics and the assumptions around those initiatives on a regular basis.
There are three common methods for stress testing your plan:
• Sensitivity Analysis
• Scenario Planning and Goal Alignment
• What-If Planning Against External Factors
Before You Begin
There are a few things to consider prior to engaging any of the stress tests:
Identify key drivers: Identify the internal and external factors that may (or may not) affect your financial plan, such as a decision to expand into a new region or the cost of borrowing money.
Focus on Factors Most Critical to Your Financial Plan: Your list of drivers may be long. Identify the ones that will have the most critical impact on your plan, and develop KPIs that enable you to track them easily and frequently.
Develop a Range of Possible Scenarios: Develop multiple planning scenarios and what-if scenarios to stress test on a regular occasion. This enables you to pre-warn your executive team if the likelihood of an event seems possible so they can create a response and course correct.
Assess Potential Outcomes Ahead of Time: Assess the outcomes that may arise if a particular scenario occurs. For instance, determine the impact on revenue if hiring goals aren’t met.
Here is a breakdown of the stress tests:
1. Sensitivity Analysis
- How sensitive is my plan to a specific variable, such as sales that are lower than expected, or if insurance rates go up?
- What is the impact of specific variables on my cash flow, balance sheet and P&L?
Sensitivity analysis doesn’t require you to change your underlying plan at all. All of the basic structures remain the same, you simply change the value of a specific variable.
Why Do Sensitivity Analysis?
- It’s a quick way to monitor the financial metrics you’ve identified as growth drivers.
- It allows you to understand the impact of a change in a specific variable on your financial sheets.
- Sensitivity analysis can serve as an early warning to an issue that your executive team or Board of Directors may need to address.
- You can update your forecasts based on the analysis.
2. Scenario Planning & Goal Alignment
Financial plans are thoughtful documents – the result of setting goals and establishing a course of action to achieve them. While the future may be uncertain, you still need to make a plan which may include hiring new employees, opening a new office, releasing a new product, or even acquiring another company.
In scenario planning, all of the factors that come into play are within your organization’s control. You decide whether to expand your sales staff or not. You decide whether to upgrade your telephone system or not.
Although you have control of these factors, your plan can still be upended. For instance, you may need to explore the impact of structural changes on the company given the continuing downturn of the economy. What if the company divested itself of the New England division; how would this action affect profitability? And are there any hidden surprises that may come back to hit the company’s balance sheet 12 or 18 months from now?
Scenario planning differs from sensitivity analysis because instead of changing a single variable, the underlying plan must change. Having to close the New England division will decrease workforce, facilities and many other expenses. But it will also affect your overall revenue, because you’ll have fewer sales reps selling your product. You may also lose customers who prefer to work with someone local.
Why do Scenario Planning?
- It allows you to test the assumptions you make, and to see their impact on your financial statements.
- By accurately forecasting the impact of a scenario, you can confidently make recommendations to the executive team.
- You can test multiple scenarios and provide the executive team with pros and cons for each.
3. What-If: Planning Against External Factors
There are numerous external factors that can have a significant impact on your financial plan – and as we look ahead to 2023, those external factors will continue to be volatile and likely affect financial plans. Interest rates, inflation, gas and oil prices, supply chain issues – a potential recession around the corner – all are factors that you have no control over, which is where what-if planning comes into play.
By implementing what-if planning at your organization you can be forewarned of the impact on your financial statements and prepare a strategy for adapting ahead of time.
What-if planning can be defensive — how will we make our numbers in light of the reduced demand for goods? Or it can be offensive — how do we exploit a market opening created when a competitor closed its doors?
Like scenario planning, what-If planning accounts for multiple variables, e.g. does the rising cost of jet fuel make it more feasible to relocate engineers to a new AsiaPac office? Or is it better to keep sending US-based teams to clients? In other words, what-if planning requires you to change the underlying plan.
Why Do What-If Planning?
- It allows you to test the assumptions about potential external factors and see their impact on your financial statements.
- By accurately forecasting the impact of each what-if scenario, you can pre-warn the executive team, so they can make contingency plans.
- It allows you to arm the executive team with answers when investors ask how the company will deal with external factors, such as the effects of the rising cost of fuel on travel expenses.
Best Practices for Stress Testing Your Financial Plan
Start with KPIs. Establish KPIs that will allow you to assess whether or not your company is meeting its goals, as well as the potential impact of internal and external forces on them.
Keep it manageable. Focus on the KPIs and assumptions that have the least certainty, or are the most susceptible to change (e.g. uncertainties around short-term steel costs which could have a significant impact on manufacturing production and pricing). Tracking too many variables can lead to ‘analysis paralysis,’ which is why it’s best to keep it simple, while ensuring the analysis provides the necessary information to make confident decisions.
Collaborate. Engage all relevant stakeholders for each scenario. For example, your shop floor supervisor can model different capacity planning scenarios to handle fluctuating steel costs.
Analyze Often. Compare actuals to plan, and perform sensitivity analysis on key variables as often as possible, preferably on a weekly basis. While that may seem like a lot of work, think of it as giving your organization 52 chances a year to make corrections. Update rolling forecasts as required.
Lose the Spreadsheet. It’s difficult enough to create a plan in a spreadsheet, and nearly impossible to change as you test multiple scenarios or what-ifs. Adopt a tool that will process all inputs according to your business structure and automatically update all of your financial outputs – P&L, cash flow, balance sheet – based on your testing.
Test Frequently. In times of flux, flexibility is key. Look for a tool that allows you to build and test an unlimited number of models, without changing the underlying code. Treat scenario planning as an ongoing decision management tool, testing multiple possibilities so you have a range of multiple outcomes. Done well, scenario planning allows you to adapt quickly to market changes, as well as present the leadership team with enough insight for them to make the strategic business decisions that will keep the company afloat.
Enable Self-Reporting. Select a tool that provides self reporting and fosters collaboration, so that other stakeholders can stress test their portion of the plan. Also, ensure the tool has customizable reporting so you can track and forecast the financial metrics that are key drivers of growth for your organization.
Stress Test Your Budget
As discussed, the ability to test various scenarios and see the implications on your financial plan is critical to your company’s future financial health. Centage’s cloud FP&A platform, Planning Maestro, lets you quickly and easily create unlimited versions of your plan – all year long – turning it from a ‘one-and-done’ annual activity to a critical, year round what-if scenario resource for decision makers throughout the organization:
- Promotes collaboration so that all of the business owners can update the budget and assumptions. Planning Maestro offers customized views, role-based security and built in financial rigor so that employees can see only the portions of the budget they need to, and that all input is fully compliant.
- What-if and scenario planning capabilities allow you to change the underlying model on which your plan is built via dropdown menus. The ease of use means you can test an unlimited number of scenarios.
- Your forecasting process will be more productive and accurate so you can routinely deliver detailed business predictions, enabling your leadership team to make faster, more informed decisions that are driven by actual results.
- Customizable KPIs, robust business analytics, accurate financial reports and dashboards put critical information at your fingertips, allowing you to easily compare budget vs. actual performance reporting.
Centage provides modern FP&A software solutions that empower Finance teams to lead the way to a stronger, more agile business. Our cloud platform, Planning Maestro, makes sophisticated budgeting, planning, and forecasting easy and accessible. Intuitive automation accelerates workflows and improves accuracy, enabling Finance leaders to deliver reliable information and meaningful insights at the speed of today’s business. For more information on how to modernize your FP&A process, view our product demonstration video, or call 800-366-5111.