Financial Scenario Analysis and Modeling: Six Tips for Success
Following the events that began to unfold in early 2020, business leaders throughout the world have rediscovered the merits of agility. Virtually all businesses produce budgets and build plans for the future, but when unpredictable events occur, managers need access to tools and analysis that can guide them in making quick, well-informed decisions.
Even when conditions are more predictable, financial scenario analysis can be useful in helping executives to set the strategic direction of an organization. By modeling multiple different situations, analysts can make educated guesses as to what various outcomes might look like. That, in turn, can serve to align strategic objectives with short-term and mid-term decisions, while also accounting for risk tolerance.
Financial scenario analysis and modeling is fundamentally about answering the “what if?” questions that inevitably arise as business leaders consider the various options in front of them. Very often, organizations build financial models around a trio of potential outcomes: best case, worst case, and a baseline scenario that typically lies somewhere in between the first two.
But you can also design financial scenario analysis to provide insight into two or more potential courses of action. Executives considering a mergers and acquisitions (M&A) strategy, for example, might wish to compare the likely outcomes of buying one of their direct local competitors versus expanding regionally by acquiring a company in an adjacent territory. Likewise, they may wish to look at vertical integration opportunities and consider the potential results of acquiring a company’s products that are highly complementary to their own.
Regardless of which type of financial scenario analysis you are doing, here are some tips for producing accurate and useful models
1. Clearly Define Your List of Scenarios
The starting point for any exercise in financial scenario modeling is to clearly define the scenarios before you. This may be a best case/worst case/likely case approach, or it may involve multiple potential courses of action, which very often are mutually exclusive. Whatever the case may be, it’s important to describe those scenarios at a level of detail sufficient to establish clear alignment as to exactly what they mean.
Even the phrases “worst case scenario” or “best case scenario” may imply different things to different people. For some, the former might suggest events and variables that are extreme outliers, that is, so improbable as to be hardly imaginable. For others, “worst case” might be based on real-world conditions that the company has experienced in the recent past.
In other words, it’s good practice to write up a narrative summary of each scenario, outlining the overall approach and defining the parameters around which you build each scenario. That will provide clear guidance to anyone using the analysis as a basis for business decisions.
2. Focus on a Few Select Variables
To avoid making your financial scenarios too complicated, resist the temptation to build them around a large number of variables. Consider, for example, a set of scenarios intended to evaluate pricing strategies for a new product. Clearly, one of the variables in your model will be the selling price of the product. You might also want to allow for a few different options related to distribution strategy such as direct online sales, big-box retailers, or regional distributors. Each of these will have an impact on sales volume and margins, which will be important factors in reaching some conclusions about potential outcomes in each scenario.
As you get beyond using just a few of the most important variables, though, things can start to get excessively complicated. Imagine that you expand that scenario modeling exercise to include the overall health of the economy, rates of inflation, or changing consumer preferences. Although these things matter, they can quickly turn a useful scenario model into an exercise in futility. Keep things as simple as possible, while still exploring the impact of changes to the most important variables.
3. Be Sure That All Other Things Are Equal
Just as there are certain factors that will vary among two or more comparative scenarios, there will be a number of other factors that should remain constant. It helps to build each scenario within a set of financial models around a similar structure, even to the point of linking to a common source of reference data so that changes in any of your baseline assumptions will automatically be reflected in each scenario model. This will guarantee that you are doing an “apples to apples” comparison.
4. Explicitly State Your Assumptions
A corollary to the “all other things equal” rule is that you should state all assumptions explicitly. In many cases, the assumptions underlying each model will be incorporated into the scenarios themselves. In other words, they will be reflected in some of the numbers built into your analysis. Examples include estimated gross margins, personnel costs, or other percentages or dollar figures in the models.
In other cases, though, your underlying assumptions might not be so obvious. Consider, for example, a set of scenarios that explore sales volumes for a new product throughout the coming year. If the company relies on end-of-the-year holiday sales for a major portion of its top-line revenue, then you will likely build your scenarios around an assumption that the new product will be released by October, and that the company will not experience any quality issues or bottlenecks in manufacturing or distribution. If that is the case, say it explicitly. While many stakeholders may assume that these assumptions are clearly understood, experience has shown that it helps to be crystal clear about these kinds of underlying expectations.
5. Solicit Stakeholder Input Along the Way
Finally, it’s important to work with stakeholders throughout this process to solicit their input and capture any potential variables or assumptions that might otherwise be missing. Reach out to key participants in various departments and explain the scenarios being modeled. Describe the key variables and underlying assumptions, and ask “What are we missing?” Very often, this process will uncover additional assumptions that you should specify, or variables that you might otherwise overlook.
6. Use the Right Tools
Although many companies begin the process of scenario modeling in a spreadsheet program, finance users often find it difficult to model more than a couple of scenarios simultaneously. This, in effect, limits their scope for making the most effective decisions.
Another challenge of using a spreadsheet program for scenario modeling is that finance users often struggle to keep up with constantly changing inputs. As new financial information becomes available, it only makes sense to update scenario models with the latest data. If you cannot update your financial models in real time, with automatic integration from your enterprise resource planning (ERP) system, then you’ll have to resort to manual methods of extracting financial data from your software and importing it into your scenario models.
That’s a tedious process. It’s slow, time-consuming, and prone to errors. A far more practical approach is to work with financial analysis tools that link directly to your ERP software in real time. Updating financial models becomes as simple as hitting a “refresh” button. This approach supports driver-based models, allowing finance users to easily change inputs and assumptions and manage different versions of each scenario model with ease.
With the right tools, finance teams can take full control of reporting and analysis, building meaningful financial scenario models that equip business leaders with the information they need to make good decisions in a rapidly changing world. To learn more about how insightsoftware can help your finance team succeed with financial modeling, contact us today for a free demo.
Guide to Scenario Modeling in Financial Analysis
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