The Greek Philosopher Heraclitus, once said that “Change is the only constant in life”. Between the COVID-19 Pandemic and the corresponding economic impact, it feels like change is a daily part of the business world. In the Financial Planning and Analysis world, one of the tools we use to anticipate and mitigate risk is called a scenario analysis.
Best/Worst Case Model Scenario
One popular form of scenario analysis that we compile is based on the Best/ Worst case model.
The first step in completing this analysis is to develop the base-line scenario. This is the average/ status-quo scenario. The assumptions used are standard assumptions provided by management. This is meant to show what happens if nothing changes and the business follows its historic trends.The next step is to prepare the best- and worst-case scenario.
The best-case scenario is typically the most positive and optimistic outcome that the company anticipates. This is typically the one that management tries to put into action. The worst-case scenario is the one used when modeling out all the potential items that can go wrong. This is typically done to reflect the most serious and negative situation the company may find itself in. Beyond running the numbers in this pessimistic scenario, management should have an operational plan ready to implement should this scenario come to fruition.
Identify Key Assumptions
Now that we have identified the different scenarios to model, it’s important to identify key assumptions that should be included. The first assumption to include would be sales metrics. These can include such items as revenue by product line mix, year over year growth, lead conversion percentage, customer acquisition cost (CAC) and average purchase value among numerous other metrics. Ideally, the goal is to pick the key sales metrics that you want to use to guide your decision making process.
The next assumption you want to iron out will be anything related to your gross margin. The most common assumption that we use is cost of goods or services as a percent of revenue. However, you can use any metric that you feel will correctly impact your cost of goods/service and thus your gross margin.
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The third assumption to identify is all operating expense/overhead drivers. Less sophisticated analysis will typically model the operating expenses as a percent of revenue. It is recommended to buildout schedules to project out headcount cost and occupancy/rent as those are typically two of the largest spend items a company will have. It is also important to build out those two sections instead of relying on basic percentages of revenue so that it shows how hiring plans can change by scenario.
The fourth and final assumption that is important to identify are all the other items not included in the first 3 sections. One example is income tax rate, while another would be interest rate on outstanding debt. It is also recommended to include other items here like accounts receivable/payable days, time of inventory turnover, any equity or debt issuant or repayment.
While a lot of scenario analysis discussed above focuses on the P&L and are heavily top-line and OPEX focused, I did want to add that these analyses are important for the balance sheet as well. For example, inventory levels, collections activities, capital expenditures and debt servicing can have big impacts on cash and bank covenants. By adjusting these variables, business owners can see how their decisions will impact many of the benchmarking ratios that they are judged on. For example, the Quick Ratio, which measures the overall liquidity position of the company, is calculated by adding cash and cash equivalents, short-term investments and net receivables and then divided by total current liabilities.
By making adjustments to the inputs in the scenario analysis, companies can see the effects of their decisions on the current ratio. Another ratio that scenario analysis is extremely helpful in projecting is a debt service ratio. This is calculated by taking EBITDA less stockholder distributions and dividing it by the sum of the current portion of long term debt and interest expense. This ratio is typically used by banks for loan covenants so it is extremely important to use scenario analysis to model out the future impacts to it. By doing these analyses before making a business decision companies can make sure they don’t risk defaulting on their loan covenants.
Companies can use these tips to protect yourself from long-term adverse effects. Setting yourself—and your business—up for financial success is a foundational step towards a prosperous enterprise.
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