Against the Odds: Hedging Your Bets with Scenario Planning
Now more than ever, strategically minded CFOs are turning to corporate performance management (aka CPM, enterprise performance management, or EPM) software to collect, validate, and store planning data in a single, central location.
By moving away from disjointed spreadsheets, companies can better focus on critical questions such as: How are we planning to hit particular targets? Who is accountable for achieving those particular results? And ultimately, why did we achieve different results than we expected?
With the benefits of CPM firmly established, forward-thinking CFOs are envisioning the next evolution of CPM—where the focus is on maximizing enterprise value by setting targets, screening for new business opportunities, and managing risk.
To achieve this, however, CFOs have to take a top-down view of the business. In this environment, the importance of individual silos gives way to more agile and aggregate views of the business that are rooted in the evaluation of cash flow and discounted cash flow as a common metric.
A top-down approach enables executive management teams to evaluate multiple active or live (concurrent) scenarios so they can engage in discussion and debate and ultimately form consensus in order to set highly measurable strategic targets.
Multiple Scenarios Create Benefits—and Challenges
Running multiple scenarios to continually screen for alternative opportunities and risks is an obvious benefit. But it can present challenges as well.
The main reason is that standard CPM techniques often create an explosion of data inputs that need to be maintained over a period of time. This is because unlike traditional point-in-time scenarios, where the version is locked for editing, live scenarios are not locked down. For example, if the initial scenario has 1,000 data inputs, each additional live scenario will create an additional 1,000 data points to manage. Trying to manage several live scenarios at the same time is both inefficient and error prone.
The Need for Interlinked Scenarios
When it comes to financial modeling, we often talk about the need for interlinked account relationships, such as cost of sales as a percentage of sales. But we almost never talk about the need for interlinked scenarios (where “scenario X” is linked in some way to “scenario Y”). Yet in a top-down environment, where the focus is on maintaining or screening for multiple scenarios, interlinked scenarios are critically important.
Interlinked scenarios enable modelers to update an assumption in one scenario and have it automatically impact or link to other live scenarios by default. This approach enables modelers to focus on entering only the assumption differences across scenarios, which in most cases represent only a very small subset of the overall number of assumptions.
Proven Techniques of Strategic CFOs
Below are three popular scenario techniques strategic CFOs use that greatly benefit from interlinked scenarios:
Corridor planning is the ability to see a band of alternative outcomes based on the continuous update of a single expected or consensus scenario. It gives modelers a broader understanding of what would happen if key assumptions are slightly exceeded or missed.
The most common example of corridor planning is a simple high-revenue and low-revenue set of scenarios. Under this approach, modelers maintain a single set of assumptions across their entire expected scenarios. They then place specific markers on the key assumptions they would like to see impacted by a slightly higher or lower assumption. For example, let’s assume that in the expected scenario there are 1,000 total assumption inputs of which a revenue growth rate of 12% is one.
With corridor planning, modelers could then enter +5% in the high-revenue scenario and -5% in the low-revenue scenario. As a result of entering just two additional inputs, the modeler can now see the impact of a 12% growth, a 17% growth (12% + 5%), and a 7% growth (12% – 5%) across the entire income statement, balance sheet, and cash flow. By introducing interlinked scenarios, the modeler only has to maintain 1002 inputs (1000 + 2) rather than 3000 (1000 * 3). If the expected growth rate on revenue changes to 15%, then the corridor will automatically shift (to 20% and 10%).
In the previous corridor planning example, the need for interlinking scenarios was based on mutually exclusive scenarios (what if revenue is high or low?). When evaluating multiple live scenarios, it’s important to realize that many scenarios aren’t evaluated based on a “this or that” basis. Instead, in order to maximize opportunities and minimize risks, CFOs also want to look at scenarios on an and/or basis (mutually inclusive). What if we invest in this new business and the market demand for our core products goes down?
By relying on interlinking scenarios, modelers can create scenarios that are calculated based on the ability to toggle multiple, mutually inclusive scenarios on or off. By doing so, they can see the financial impacts of two or more events happening at the same time.
This is critically important. Companies often get in trouble when they evaluate certain investment decisions only under favorable risk conditions. On the other hand, combined scenarios enable CFOs to evaluate investment decisions under multiple risk factors.
Oftentimes, major investment or acquisition opportunities are delayed by six months or one year. This can have a substantial impact on earnings or funding. As a result, it’s important for strategic CFOs to be able to create alternative scenarios that are interlinked in such a way that the only difference is the timing of the event. Under this approach, modelers enter data in one scenario but see the impact of timing differences across multiple scenarios (“6m-Delay,” “9m-Delay,” “1y-Delay”).
The Bottom Line
Today’s CFOs are constantly trying to navigate a world full of opportunity and risk. As a result, it’s imperative that they can make forward-looking decisions based on the evaluation of multiple scenarios.
By adopting an approach that promotes the agile benefits of interlinked scenarios, strategic CFOs will be better positioned to make key decisions and set realistic top-down targets that will enable them to be a driving force in CPM.
Leveraging a robust, bottom-up planning environment that focuses on hitting or justifying high-level targets alongside an agile top-down planning environment that focuses on setting targets, identifying opportunities, and avoiding risk is the key to achieving a high level of CPM competency.
This content was originally posted here.
Michael Huthwaite is the founder and CEO of FinanceSeer, an Adaptive Insights partner and maker of top-down planning tools focused on maximizing multi-scenario capabilities.