All businesses face external and internal pressures which can impact their financial performance and bottom line. These pressures should be analysed through “stress-testing” the financial assumptions underpinning the business’ financials.
Stress-testing financials means examining how the business will perform under a range of possible events, both negative and positive. These could include a sales slowdown, integrating a new acquisition or taking on new debt. This ability to stress-test the specific financials is critical for any business to implement change in advance of any likely difficulties.
The best method for testing for these events is to change the assumptions in the business’ financial model. All financial models are based on a number of assumptions whether they are implicitly stated or not. Assumptions can include growth rates, cash flow timing, project selection, interest rates, among many others. Each of these assumptions should be tested to determine the importance of it on the business’ performance. This testing, called a scenario, can then be used to determine the risk to the business if that assumption changes by comparing it to a “most likely” base case.
Common types of scenarios
Below are some of the most common types of scenarios included in financial models. These scenarios can be either done individually or at the same time. For example, high / low growth scenarios (noted below) are often done as secondary scenarios when testing another area.
- High / low growth – most revenue and expense items are assumed to grow in either price, volume or both. This pair of scenarios test the impact if the underlying growth assumptions are both higher and lower than expected, but within a probable range.
- New growth assumption – sometimes the underlying assumption for an item changes, such as changing from a fixed fee to an hourly fee.
- Change in timing – the timing of cash inflows and outflows is often critical to the survival of a business, particularly for large items like large project payments. The materiality of these timings should be tested by delaying or bringing them forward to understand the impact on the business’ cash reserves and other items.
- Interest rate sensitivity – for businesses with debt, it is important to understand the impact of changing interest rates in the market, particularly around refinancing. By testing a range of rates, the business will be able to understand whether the rate offered is a good deal. These scenarios are key when negotiating with banks to ensure that the business can service the debt.
- New debt facility – funding a business expansion with debt is often a difficult decision. The funding arrangement can be tested using a number of scenarios. For example, scenarios on the facility limit should be done as part of the question of whether debt should be accessed at all.
- Dividend policy testing – these scenarios test how much cash can be distributed by a business without hampering operations. The amount calculated can be done using either calculating the total free cash available or by using a required rate of return for each shareholder.
Including a Scenario Manager
When preparing a financial model, scenarios are often only considered at the end of the process. This can result in a significant amount of time and effort in redeveloping the financial model to allow key assumptions to be tested as scenarios.
At Pilot Partners, we promote the integration of a Scenario Manager worksheet in a financial forecast from the start of the development process. The Scenario Manager acts as a single point of reference for all key sensitivities in the model, where they can be altered or left unaltered depending on the scenario being tested. Advanced Scenario Managers allow for multiple scenarios to be set-up and tested in series or in parallel depending on the complexity of the model.
For more information on scenarios and how Pilot can assist you integrating them into your financial model, please contact Chris King from our Corporate Advisory division.