Contributed by Helen Dow, Finance and Accounting Director, Warren Whitney
Introduction
Regardless of your line of business, it is likely that you are feeling a degree of uncertainty in how your operations will be economically impacted over the next year or so. Change and its impact seems to be on everyone’s mind. This article will focus on how to survive and even thrive through downturns and losses, along with opportunities and growth, which can be just as dangerous if mismanaged.
Like a change in the weather, we can see and feel it and are looking to understand how to prepare and manage for its impact. Consider inflation, tariffs, interest rates, recession, government shifts in priorities and spending, supply disruptions, labor challenges, and also how each can influence the other. You may have additional impacts specific to your industry and position in your market.
The good news is with proactive management, there are tools to use to measure and navigate through. I love analogies and one that is applicable is the training for and preparation in case of a fire. It’s taken for granted and seemingly straightforward unless you haven’t prepared. If a fire occurs, knowing where and how to use fire extinguishers, the exits, drills, who to call, insurance coverage and other continuity plans changes the results. Think about a simple spot fire and the different outcomes for the prepared versus the unprepared. The same applies to internal and external challenges to the operations of your business. This preparation builds skills and the confidence of your team, giving the best chance at minimizing damage.
Now a fire is much more immediate, and you think that you have more time in the case of an impact from tariffs or the loss of funding. Maybe so, but how long would it take you to build a business model that you trust? It takes time and experience. When the pandemic shut down our entire operation, I had a tool already built, already tried and trusted that I was able to model how many days we could survive (we were too big for government assistance). With that knowledge we modeled how many key employees we could keep. And we were able to make the decision with confidence that we could continue paying the furloughed staff their health benefits. This is a real example of a tool that helped make a big impact to our survivability through a tough time and enhanced good decisions that benefited our employees.
Risk Analysis
The first step is to identify the risks and evaluate areas that need to be modeled. In my opinion, the best tool for this is a SWOT analysis. This stands for Strengths, Weaknesses, Opportunities and Threats and many of you have some familiarity and may have participated in these. Think about the different teams that you can benefit from this exercise, such as your board, executive team, management and departments. Below are some of the benefits to expect when completing your SWOT analysis.
- An understanding your internal strengths can help you maximize your external opportunities or minimize the threats.
- Identifying your internal weaknesses gives you time to improve them, especially if it correlates with an expected threat.
- Opportunities are generally, external areas of expansion and growth. Don’t miss the correlation mentioned in the first bullet on strengths. External opportunities can also exist that increase your internal strengths of industry knowledge and best practices.
- Threats can be assigned a probability and work through impacts. Teams can help identify areas that might otherwise be missed.
- Provides a working list of the risks and their impact to use in your model.
- Builds confidence for your team. Just as in the above analogy of a fire, if an event occurs, your team knows what was identified and the resources that are available.
Prioritize the results of the risks identified by probability level and impact to the business. High probability and high impact need to be modeled.
Drivers and Metrics
What drives your business? What inputs are necessary to get the outcomes you need? What activity drives revenue or shows whether you are successful? These become your Key Performance Indicators or KPIs.
What are your assumptions on future impacts of inflation, revenue growth, margins, compensation costs? These are your metric variables.
Know your ratios that measure financial strength. What are your days-in-cash (the number of days you could operate if income went to zero)? What is your current ratio (measures the ability to cover short term liabilities with short term assets)? Or your fixed charge coverage (the degree of ability to cover debt service and lease obligations)?
What are your operational efficiency ratios? These are measure things like turns of inventory, labor productivity ratios, days in receivables, sales conversions, etc.
Fixed and Variable Costs
You will need to evaluate your costs and expenditure needs.
- What are your debt service costs?
- What costs are fixed, temporarily fixed and are variable?
- Do you allocate costs and if so, do you know the costs that would be pulled back if a department or program was discontinued? For instance, if you allocated your payroll costs to a department that was discontinued, there is a good portion of those costs that would likely need to be reallocated.
- Do you have capital expansion or replacement costs, and have you estimated its timing?
Scenario-Based Budgeting
Now we are going to pull it together in a budget that is built to model the risks, measure performance and most importantly monitor critical areas like cash levels, bank covenants and performance metrics.
- Start with a history of a couple years’ of a summarized, income statement. Build it in your accounting system to allow for easy updates. This should be grouped by major program or department. Showing the least lines able for each major operational area, for instance Revenue, Cost of Sales, Margin, Compensation, Allocated Costs and everything else in one line if you can.
- Reference, with formulas, your drivers on a separate summary sheet.
- Build out by month. Go out as far as needed. Don’t worry about the popular misconception that there isn’t value in going out more than a couple years. If you have a major event in three years … or six, go out that far. Although at that length, you may want to display annual numbers.
- Below this income statement, start with beginning cash and then add and subtract cash impacts. For instance, adding back depreciation, and be sure to add capital requirements. Include debt borrowings and payments. Add any major capital needs that may be at a distance in the future. This will take you to a cash balance, your key resource. In a very simplistic way, you have an income statement, followed by sources and uses, ending with a modified balance sheet.
- Add your KPI and performance metrics at the bottom. This allows you to monitor is changes modeled will have significant impact to those metrics.
- Lastly, add any summary numbers if needed to chart trends to the totals and ratios.
- Optionally, consider including a compensation tab that budgets employee costs by employee, by department. This can be extremely valuable to model health care costs, separate increases in critical areas or spot “fixed” compensation that is modeled as variable.
Conclusion
Someone asked me what the difference is between cash flow forecast and a scenario-based budget. The answer is that cash flow forecasts are extremely important and are a part of the scenario-based budget. As the fourth bullet above discusses, you will have your cash flow numbers, and it adds other important numbers and metrics that can be as important as cash, such as compliance with debt covenants. It’s comprehensive nature to pull in all components of the financials allows you to trend metrics important to your business.
Scenario-based budgeting is built to model multiple threats and opportunities with changes to the drivers and impacts to key revenues and costs. Because it is a summary report, built by department, it quickly becomes understandable in ways other financial reports can’t. And in a way that allows you to model and focus on an almost unlimited set of variables that are important to your unique business.
Thank you to Helen Dow and the rest of the Warren Whitney team for providing this article for us, and for being one of our most trusted partners.
Warren Whitney’s Finance/Accounting team works with business leaders to strategically evaluate your best path forward. Our work includes serving as your fractional CFO/Controller, advisory services, and financial consulting. If you have any questions or seek further clarification, please call us at 804.282.9566 or email Kyle Ficker at kficker@warrenwhitney.com. We do not charge for the initial call. We want to learn more about your business needs.
