Every business has a set of interconnected levers, commonly referred to as business drivers, that affect the operational expenses and financial results. Common business drivers include personnel, physical stores, various product lines, units of production and so on. For instance, the more sales staff available, the more revenue to be gained, but the more expenses are incurred.
When all of your key drivers are aligned and impact the business in a positive way, your business will grow. The key is to have a keen understanding of your business drivers, and build your financial plan around them.
For instance, let’s say the Board of Directors of a hospital has set a goal to grow the business by 20%. There are multiple paths the hospital can take to achieve that goal: add more beds, raise the price of services, or provide more services to existing patients. If the decision is made to add more beds, staff becomes a critical driver, as hospitals must maintain a specific ratio of nurses to patients. Therefore, setting KPIs for recruiting qualified staff is a critical driver for growth.
Or, let’s say a manufacturer has a five-year goal to grow from a $20 million to a $50 million company. The plan must identify critical drivers to meet those goals, e.g. unit price, number of units sold, number of salespeople needed to meet that objective, along with marketing investments required to support the sales team and so on.
Role of Financial Scenario Planning
While driver-based budgets are highly accurate, it’s rare that all drivers will align. Interest rates can go up, recruiting candidates may take longer and cost more than anticipated. The delta between forecasts and actuals can have a huge impact on performance.
Scenario planning allows you to connect these drivers, and mix and match different variables based on certain conditions to see a range of outcomes.
There are three types of financial scenario planning:
Financial Scenario Planning
Number of variables
What’s actually changed
The numbers and/or the plan
Internal or external factors
Sensitivity analysis is the quickest and easiest of the stress tests, in that it tests just one variable. Essentially, sensitivity analysis allows you to answer such questions:
- 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.
Financial Scenario Planning & Goal Alignment
Financial scenario planning differs from sensitivity analysis because instead of changing a single variable, the underlying plan must change. Closing 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 Financial 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.
What-If Financial Scenario Planning
There are numerous external factors that can have a significant impact on your plan. Exchange rates, interest rates, the price of oil and even the entire economy can go up or down. Many companies are affected by catastrophic weather, political turmoil or current events.
Obviously these are factors you have no control over, but with what-if planning, you can be forewarned of their 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 these developments?. Or it can be offensive – how do we exploit a market opening created when a competitor was fined by the EU?
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 higher tariffs or new regulations.
Get the Right Tools
It’s extremely difficult to do any kind of financial scenario planning using a spreadsheet. You’ll need to piece together multiple spreadsheets, and rely on complex formulas and macros to arrive at answers. Doing that once takes hours; doing it dozens of times to test multiple scenarios is impossible.
A specialized FP&A platform like Planning Maestro, on the other hand, streamlines the entire process. It automatically processes all inputs according to your company’s unique business structure, and automatically updates all outputs, such as your P&L, balance sheet or cash flow statement. It is activity based, and flows inputs through the financials based upon the logic and rules established automatically, without any programming are your end. You can easily test one or multiple internal and external factors and gauge their impact on your financial statements.
Centage Corporation’s Planning Maestro is a cloud-native planning & analytics platform that delivers year-round financial intelligence. With Planning Maestro, Centage offers the sophisticated features needed by small and mid-market organizations to integrate budgeting, forecasting, and deep data analysis within one easy-to-use, scalable SaaS solution. For more information on how to modernize your office of finance with intelligent planning, view our product demonstration video, or call 800-366-5111.