Updated 24 January 2018
It used to be the preserve of big businesses – using sophisticated financial models to plot possible future business outcomes. But modern accounting is levelling the playing field. Rachel Lawrence of accountants Albert Goodman LLP explains why scenario planning isn’t just for the big boys.
I’m always amazed at how many important business decisions are made ‘on the back of a fag packet’ or on a gut feeling. One reason for it is that small business owners don’t see how else to do it. Historically, only big businesses have been able to make use of scenario planning to consider multiple possible outcomes, and so avoid costly mistakes. However, the proliferation of this skillset beyond the Big Four accounting firms, along with developing technologies, means SMEs can now get in on the act.
Many a client has told me that they want to go ahead with a project on a certain basis, only for that decision to change completely after a ‘What if?’ analysis. For instance, one client approached us with a clear plan for opening a number of new business units. Following a detailed cash flow forecasting exercise, we identified that existing business units had substantial spare capacity, so the opening of new units was delayed until the capacity was required. This was a radical change of plan, and yielded dramatic cost savings.
It’s all very well to project significant growth in turnover as a result of a business idea, but is that realistic? How quickly can the business gear up to achieve the growth? How much recruitment is needed? Is there a link between staffing and the generation of turnover? Are the current premises big enough? Is there room for all the stock? The moment you consider a new direction, the questions and possible scenarios multiply.
Using a well-designed financial model can demonstrate the direct impact of such scenarios on cash flow. It can identify working capital constraints, cash shortfalls or pinch points, and how much these might be. This can feed into your funding plans and suggest whether you might need extra short-term or long-term financing.
What will happen to your project if there is an unexpected event, such as a delay? What are the cost implications, and how will this impact on the profitability of your business and cash flow in the short to medium term?
A good example is the move to new premises – I’ve yet to hear of one that didn’t spring a few surprises. If the move date is delayed or the actual move overruns, this may have implications such as the need to pay rent and overheads on two properties, or potentially operating at reduced capacity (which will hit turnover). If you own the property that is being sold, a delay in sale will have implications for repaying loans and working capital.
However, if you’ve done your scenario planning, you can have contingency plans in place and have the necessary discussions with banks in advance, to ensure their support with a financing plan for such eventualities.
Are you looking for funding? Finance providers will have more confidence in your business if you are able to produce credible cash flow forecasts. By demonstrating that you have considered multiple key scenarios and their potential impacts, you can reassure banks of your ability to repay.
A case in point is the financial modelling exercise we performed for a client who planned to grow into new markets and potentially make an acquisition. This meant that, when a suitable opportunity came along, they already had a model they could use. Consequently they were able to secure over £1million of finance from their existing bank for the acquisition of a competitor, within the space of four days.
It may seem obvious, but if you have undertaken scenario planning you will be better equipped to enact and achieve your plans. As a next step in cash flow forecasting, we typically include actual results feeding directly from a client’s accounting system so that these can be compared to budget. The result is a rolling forecast which enables close control both of costs and the business. This in turn can generate key performance indicators (KPIs) for the management team to use.
One of our clients, the owner of a domiciliary care business, was struggling with the escalating costs of training staff in a sector with both high staff turnover and ever-changing training requirements. Through scenario planning we were able to determine the critical point at which it would be more cost effective to bring training in-house – renting a training room to do so – rather than paying for external training courses. For the first time, the client could see clearly that this threshold would be crossed within the next couple of months, rather than being just an idea for an unspecified future time. The exercise led directly to the client taking control of their costs, making crucial changes to a business with very sensitive margins.
No-one can predict the future with total accuracy, and it’s no different for a business. But the alternative doesn’t have to be guesswork and crossed fingers. In the absence of a crystal ball, scenario planning is the most reliable indicator not only of what might happen, but of what could be achieved and how such opportunities might arise. As such it’s far more than just a safety measure; it can be the key to future success.
Rachel Lawrence heads the Financial Modelling and Renewable Energy team at Albert Goodman, a firm of chartered accountants and one of the largest accountancy and business services firms in the South West.