During times of uncertainty and economic downturn it’s crucial for businesses to determine as many potential outcomes as possible. This way they can take preparatory action and avoid unwanted surprises. There could be threats on the horizon relating to rising costs, poor market conditions, and recession.
Financial scenario planning helps to improve forecasting by evaluating a range of risks and opportunities. However, many companies perhaps don’t fully understand the intricacies of scenario planning (and are yet to implement a dedicated strategy).
In this article, we define what financial scenario planning is, and explain the benefits it can bring about. We also highlight the different types of scenario planning used by businesses and explain how to implement an effective scenario planning strategy within your finance team.
What is financial scenario planning?
Scenario planning is essentially concerned with analysing a range of factors to predict future results. Projections can be made by inputting possible outcomes into calculations. This could involve analysing the impact of particular business decisions internally. Or it could be assessing what would happen as a result of external circumstances.
This activity helps with understanding each of these specific scenarios, while also making it easier to formulate appropriate countermeasures. From a financial perspective, scenario planning assists with estimating income / expenditure, profitability, cash flow, and overall financial health during uncertain times.
By providing an evaluation of many eventualities, financial scenario planning gives businesses the best chance of a positive result, while giving financial decision-makers the information they need to prepare alternative actions where necessary.
Importance of scenario planning in finance
For finance managers, scenario planning is crucial during times of uncertainty. Take the current situation in the UK as an example. Finance teams that utilise predictive analytics and carry out scenario planning are better equipped to navigate the cost of living crisis. It’s this valuable insight which can shape the future of a business during an economic down-turn. The benefits of effective financial scenario planning include being able to:
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Forecast performance
By gaining insights into plans, budgets, and key drivers of business growth, as well as a detailed picture of future outcomes, finance leaders can forecast better and ultimately have a strong foundation for making strategic decisions more effectively.
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Minimise risks
Potential negative outcomes become clearer, as well as the associated preventative measures. Therefore, proactive decisions can be made to negate these risks.
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Gain a competitive advantage
As a result of scenario planning, you'll be able to act quickly and decisively, while having a more centralised structure for important business decisions. These improvements could give you an edge over competitors.
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Leave less to chance
When deciding upon a potential investment, business leaders can analyse the return on investment and wider impact. This way they are making an informed decision rather than letting results be determined purely by instinct.
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React quickly
In the event of a crisis, the finance manager has the relevant information (and tactics to deploy) at their fingertips, as the scenario has already been accounted for. This means there are no costly delays while figuring out what to do.
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Future-proof your business
By analysing market conditions and industry trends, safeguards can be put in place to deal with likely occurrences. As a result, the business is likely to maintain its longevity, rather than being devastated by some unforeseen situation.
What are the types of scenario planning?
Here are some of the most common scenario planning models used:
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Base case scenario
This is essentially the average scenario that might occur. By looking at the financial performance of the last few years and projecting this into the future, it becomes possible to predict the forthcoming year.
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Best case scenario
In some cases, managers will use the best-case scenario for setting goals, as this can be an effective way to hit targets and to push their team to go the extra mile. When determining this scenario, they must envisage a year in which the loss of existing customers has been kept to a minimum, and sales numbers are as high as realistically possible.
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Worst case scenario
For this model, it’s necessary to determine the most extreme negative outcome for the business. This is a useful way to come up with solutions to the worst problems (and to put the relevant safety nets in place).
The above models look at the different levels of scenario a finance manager will need to assess, whereas the following show the different types of scenario planning that can be used:
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Quantitative scenario
This model is often used when finance teams are creating budgets, as it considers a number of financial variables before producing a reasonable output. These variables can then be adjusted quickly as and when the situation changes, or if the team want to take another scenario into account.
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Normative scenario
With normative scenario planning, more importance is put on specific goals. Rather than simply predicting the future, the business tries to influence outcomes by embedding their objectives into the plan. This model is often used in tandem with other models to drive desired changes.
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Operational scenario
This method analyses the effect a particular event would have. This helps businesses to understand whether their operations would withstand the event, or whether their strategy must be altered accordingly.
How to implement financial scenario planning
Below are six steps that assist finance teams with implementing effective scenario planning:
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Determine key metrics
In any scenario planning model, the team should first identify the metrics that matter most to them. Only then can they uncover how these elements of financial performance will be affected by internal and external circumstances.
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Gather data
It’s important to gather as much historical data as possible when forecasting outcomes. The larger the amount of high-quality data inputted into calculations, the more accurate the output will be. This could include any relevant finance, sales and marketing data from the processes / systems already being used.
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Predict scenarios
It can also be beneficial to simplify matters. By trying to predict everything, you may end up overcomplicating the situation, with no real grasp of any specifics. It’s perhaps better to focus on a few key uncertainties and develop detailed strategies around them.
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Develop a response plan
Strategies should then be outlined in enough detail so that it’s easy for the team to analyse the likely effectiveness in particular scenarios. With all the elements of the plan in place, it should then be simple for the plan to be executed at the opportune moment.
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Execute plans
The scenarios and response plans that have been developed should be shared with the wider organisation. This includes any appropriate stakeholders that may be affected, as well as the employees that will play a part in executing the plans.
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Repeat the cycle
Once financial scenario planning has been completed by finance managers and their teams, they shouldn’t then rest on their laurels. The business landscape is continuously changing, and new risks are surfacing all the time. You should review your plans intermittently, to assess their relevance and to identify these new threats.
Using Cloud financial management software to improve forecasting
At Advanced, we provide a financial management system called Advanced Financials. This Cloud-based accounting software has sophisticated forecasting capabilities, ensuring you always have clarity of what is ahead. Finances can be updated at any time and from any place, meaning data is always current. All financial activity is integrated within the system, ensuring a higher quality of unified data, and therefore more accurate forecasts.
This accounting software allows your team to plan for future cash flow scenarios, provides a clear picture of financial trends and patterns, and guides strategy through data-driven insights (rather than best guesses).
Advanced Financials allows finance teams to embrace the ‘continuous accounting’ philosophy. They can assess current / future performance in the moment and amend budgets continuously (rather than waiting for month end or the new financial year). This is made possible by the hundreds of customisable reports and dashboards which provide an instant snapshot of financial health.
If you’re interested in financial scenario planning and the benefits it can bring to your business during uncertain times, be sure to read more about our Cloud-based accounting software.
