Managing risk with financial modelling

In a complex operating environment, business plans rarely go exactly as planned, having models that replicate the all the commercials and drivers of a business allows us to stress test different elements of its operations and financials to see how it would respond to a shock.

One of the most important jobs of executives and directors is assessing and managing risk.

A lot of these risks are strategic and financial, and boards and the C-suite want to be comfortable that their risk appetite aligns with the plans and strategies they have devised before implementing.

In contrast to a few vague ‘what if’ questions, many businesses take a more methodical approach by using scenario modelling.

This often involves developing a financial model of the business or the part of the business in question, which then sets a baseline forecast for how the company will perform in the future.

From there, they can drip in a series of ‘shocks’ to see how business performance will be impacted.

What happens if revenue drops by 15% and how would that affect their ability to service debts?

Or what happens if they make a large ‘bet-the-farm’ investment and the investment doesn’t perform as expected? Where will that leave shareholders?

The financial model can help identify the quantum of the risks and provide a starting point for a plan to mitigate for those risks before any big decisions are made.

Levers to mitigate risk

For instance, a company might be looking to buy new manufacturing assets. If everything goes according to plan, the investment could increase capacity, product range and profits. And while the acquisition is of strategic importance, it will also put some financial pressure on the company by tightening its ability to service debt.

If the directors and executives believe it’s the right thing to do, how can they get comfortable that they’re not putting the future of the company at risk?

What happens if demand for the new facility’s products is 20% below forecast? How would this affect debt repayments and profits?
A financial model with scenario handler can answer these questions.

And with those answers, the executives can start looking for levers to mitigate that risk and not put the future of the company on the line.

For instance, the company could do contract manufacturing for another business, which would produce lower margins but would guarantee some volume. They could allocate a share of the new facility’s capacity to ensure running costs would be met, and more importantly mitigate the risk that the volume doesn’t match forecast.

With a model that replicates the all the commercials and drivers of a business, directors can stress test different elements of its operations and financials to see how it would respond to a shock.

In a complex operating environment, business plans rarely go exactly as planned.

Making capex decisions with confidence

In the example of the manufacturing facility, they could test what would happen if it took four years to build rather than the projected two and how that might affect the company’s debt servicing.

In fact, running over budget and/or running over time are two big risks of many business projects, be they new IT systems, construction, or other types of expansion.

Scenario modelling can give executives the answers across a wide range of scenarios for all sorts of metrics – cash flow, debt covenants, profitability and operating margin.

By looking at the base case for an investment, and then the various downside scenarios and what can be done to mitigate them, directors can be more confident when they make capital expenditure decisions that could be for millions or even billions of dollars.