For the first time in well over a decade, American businesses are looking a possible — perhaps probable — economic recession in the eye. With many companies just now recovering from the pandemic, everything from cash flow and capital investments to debt covenants and labor are once again clouded by uncertainty.
This additional risk demonstrates the never-ending importance of scenario planning and sensitivity analysis, tools that allow a company to identify and strategize for countless what-ifs before uncertainty puts operations on the ropes. Unfortunately, many financial planning and analysis teams (FP&A) aren't accustomed to integrating so much risk into their financial models, leaving the entire organization susceptible to the unknown.
Start With Cash Flow
First and foremost, when uncertainty is so pervasive, cash flow forecasting becomes an absolute necessity. Otherwise, leadership has no way of gauging how well an enterprise can navigate the countless twists and turns created by external forces like a pandemic, rising inflation, or shifting consumer expectations.
In that sense, cash flow forecasting is the foundational piece to more comprehensive scenario planning, a reference point FP&A can use to plan for risk across different scenarios. For example, without cash flow forecasting, an organization can’t adequately prepare for any larger fixed or unexpected costs. In such a case, a cash flow forecast can dictate if an enterprise needs to revisit its payables process or capital investment strategy to free more cash, areas that are invaluable to the budgeting process as well.
Using Sensitivity Analysis With Scenario Planning
Cash flow forecasting isn’t the only critical planning point for enterprises during economic uncertainty.
Leadership must also look at a myriad of other variables that can impact operations and profitability during a recession. Once financial planning and analysis cover the essentials, it can use them as a baseline to create a more nuanced approach to planning and decision-making. Sensitivity analysis uses forecasts to examine different choices and their potential repercussions, providing a better, more detailed understanding of the risks and opportunities stemming from different action plans.
Such nuance can also include the sources of risk specific to an individual company. For instance, if an international business has forecasted cash flow at the aggregate level in the past, evaluating it on a country-by-country basis going forward will help account for the differing recovery rates across the globe. Without this attention to detail, leadership can’t properly account for those staggered recoveries and, therefore, might potentially impact decision-making within a given region.
The same premise holds for different products or service lines, where particular product lines might recover much faster than others within a brand. If scenario planning doesn't integrate enough detail across product or service lines, companies won't be able to use sensitivity analysis to isolate and interpret different impacts on different levels within their operations.
Fine-Tune Scenario Planning
Between human resources, marketing, IT, sales, accounting, finance, and operations – amongst others – scenario planning depends on several moving parts working together. And each of those parts has a number of processes running within them, some that a recession might impact, inflation, or other factors affecting FP&A’s models.
Therefore, if a scenario indicates a 20% drop in a certain product line, decision-makers might look to cut costs to preserve cash flow. As a result, such measures could impact everything from labor to purchasing, making flexibility and agility critical to evolve and adapt to trends and dynamics without significantly affecting operations.
Alternatively, if a company doesn’t forecast a major disruption to cash flow and has a strong balance sheet, then an investment in FP&A tools that drive better scenario planning could very well make sense. As always, it just depends on the specific company, environment, and objectives.
Effective Action Planning
An enterprise could develop several scenarios that integrate precisely targeted insights and details, yet still spin its wheels if decision-makers don't take action on them. Thus, CFOs and their teams must also examine the different pivot points within each scenario and determine how best to respond. For example, such pivot points and responses in a cash flow model could include:
Cutting discretionary spending
Layoffs or furloughs
Renegotiating compensation packages
Revisiting partner contracts
Diversifying markets and business operations
FP&A can take a similarly thorough approach when evaluating or projecting financial earnings, developing risk management and mitigation strategies, or other decision-based processes that can help an organization efficiently and effectively deal with uncertainty.
For example, forecasting falling revenue streams ahead of a recession could help a manufacturer pivot and focus production and marketing on consumer staples rather than discretionary products. Such foresight and action planning could be a significant revenue buoy for the organization when consumer spending shifts or stagnates during the recession.
Teamwork is Essential
Cross-functionality plays another vital role in effective scenario and action planning. An FP&A team should be able to rely on input and assistance from other groups within its company, making this level of financial planning a genuine team effort. That makes communication and coordination between different departments and groups critical to success.
Without them, decision makers won’t know which financial levers to pull as uncertainty rises. This exposes the entire company to risk it could have either mitigated or avoided simply by having FP&A, sales, marketing, production, and other essential business segments both read and react to the economic tea leaves as a cohesive team.
Historical performance and figures can only get a company so far when the road ahead is so unclear. Ultimately, forward-looking organizations that can rely on thoughtful, detailed scenario planning are the ones that make it through risk and economic uncertainty most unscathed.
Stacy Galligan is managing director at Embark.