The Importance of Scenario Planning During Times of Uncertainty

The COVID pandemic has highlighted the importance of Agile Scenario Planning. This Scenario Planning technique gives businesses a competitive advantage since they proactively look at growth opportunities or tackle controllable risks. In its basic form, a financial plan is the financial representation of an organisation’s strategy. It is a way to financially demonstrate how the company’s strategy will most effectively and efficiently generate the most return from limited resources. This applies to all organisations, including small and medium enterprises (SME), public sector bodies, non-profit organisations and commercial corporates. Scenario Planning allows businesses to calculate and evaluate different situations. The key change during the pandemic to many firms was a shift in focus away from growth towards survival or solvency. The ability to evaluate how actions will impact cash flow enables a business to manage its resources more effectively and recover from the pandemic quickly.
 

Holistic Financial Modelling

Scenario Planning can be considered as a form of contingency planning. It is an integral part of the business decision-making process because businesses can use it to assess the outcome of their decisions by playing with scenarios. 

Successful financial modelling is an iterative process. Results are measured against a model’s output so that businesses can investigate the root cause and make more informed decisions. This iterative process serves two purposes:

1. An indication of how “accurate” the model is in projecting the future. 
2. It reinforces the idea that business planning is a continuous process of improvement.

A holistic approach links what happens in the top line (sales and revenue) to the bottom line (profit) whilst spelling out the investment and resources (capital investment and cash) that are needed to support the top line evolution. This means any plans that have been made using this approach will impact the cash flow, the balance sheet and the profit and loss (P&L).

Using sales as an example, the top line of revenue is typically the first focus. A holistic approach considers how the change in sales impacts cash collection (cash flow), inventory, balance sheet and the manufacturing or supply chain, cash flow and balance sheet and P&L. 

This approach also promotes transparency. Where transparency exists, the stakeholders of the different departments can have an open and frank review of all risks and opportunities. This gives credibility to the simulation and ensures that financial planning is aligned with corporate strategies.
 

The Importance of Data Integrity in Financial Modelling

Financial Scenario Planning can only contribute to business decision-making if the results are generated from reliable and consistent data and augmented with human intelligence. The commonly acknowledged attributes of good data are timeliness, consistency and accuracy, but the data should also be fit for purpose. Defining which data fits the purpose depends on which question the business is trying to answer. Time series data can provide a basis for any simulation. However, teams need to look beyond traditional accounting if financial modelling is to encompass the whole financial lifecycle, including cash flow, balance sheet and ultimately, profit and loss.

For example, time series data may not be sufficient to simulate the impact of a business opening an online distribution channel if the company does not already have a good online presence. Non-traditional inputs will need to be integrated. For example:

• Consumer buying behaviour
• Online presence and non-online presence
• Competitor analysis
• Production speed
• Inventory
• Costs to consumer online vs in-store

Some of these inputs may be available from data collected via customer relationship management (CRM) and enterprise resource planning (ERP) solutions, but they may be used disparately in other models. Therefore, to ensure a coordinated approach, the custodian of the data should be involved in the planning process to ensure the right type of data is collected for any simulation.
 

The Four Common Pitfalls in Financial Modelling

Given the importance of Scenario Planning as a tool to model and evaluate the financial impact of different situations, it is important to have an appropriate platform to deliver the simulation. Very often, organisations focus on the speed and functionality of the tool rather than reviewing its operational and planning processes.

Financial modelling is a process, and the financial model simply serves as a framework designed around this process. Therefore, inefficiencies in any part of the process should be weeded out. This will help to promote collaborative planning rather than allow planning to be a cumbersome task.

Other reasons why financial modelling fails to support Predictive Analytics include the following:

• Disconnected financial modelling

Working in silos is one of the biggest risks for financial modelling. It leads to multiple versions of the truth, distracting stakeholders from tackling the main question(s) at hand. It also leads to a lack of cash flow visibility throughout the plan. The reason for the disconnection is a lack of collaboration between the business and finance and a lack of finance leadership in the process. On top of this, occasionally, different business areas, although connected, are not always coordinated at a planning level.

• Reliance on spreadsheets

Many organisations still use spreadsheets to prepare financial plans. Although they are relatively inexpensive and readily available, spreadsheets simply do not have the capability to support complex scenario modelling. Spreadsheet tools are known to be error-prone. For example, Tesco had an accounting error back in 2014 that overstated their profit by GBP 250m due to spreadsheets. Furthermore, these tools are not collaborative because they do not allow for simultaneous multi-user access.

• Assumptions

Assumptions reflect business processes and form the basis of most model calculations. They represent the conditions in which the business operates. Ineffectual assumptions slow down the model’s efficacy and reduce the accuracy of each simulation.

• Lack of clarity

A common problem businesses encounter during financial modelling is not clearly identifying the question they want their model to answer. This clarity is the cornerstone for effective financial modelling. Otherwise, the simulations will not provide actionable insight to support business decisions. Lack of clarity can also result in endless changes to the scope and specification of the model and its simulations. Scenario Planning is not meant to provide 100% accuracy. It is designed to provide actionable insights and enable business agility.
 

Conclusion

To conclude, there are four key takeaways regarding holistic financial modelling.

• It is an iterative process that encourages continuous business improvement.
• It encompasses the whole organisation and all three financial statements.
• It requires a collaborative approach where finance and operations work together to find actionable insights.
• The goal needs to be clear in order to avoid endless modifications to the financial model or risk the model not fulfilling its core purpose.

Disclaimer: 

Any views or opinions expressed are solely those of the author and do not represent those of any companies for which the author is or has been working.

This article was first published in the SAP Blog.