The saying goes that if you fail to prepare, then you're preparing to fail. But how can businesses prepare for all possible future circumstances? The answer is, they can't. But they can make themselves as resilient as possible by carrying out scenario planning. This means considering how a range of possible futures could impact your business, and making a plan for how you might address those changes.
This article will explain the basics of scenario planning and how to go about it, including creating alternative cash flow forecasts.
What is scenario planning?
What happens if there’s a recession and your sales fall rapidly? What if the cost of your most important raw material doubles? Or what if a celebrity is spotted with your brand and demand surges?
“There are countless things that could happen [in business], and nobody expects you to plan in detail for everything,” says Simon Laurie, a senior manager with McBrides Chartered Accountants.
“But without some level of scenario planning, you’re going to spend a lot of time fighting fires in your business, when you could be working on growing it.”
While scenario planning is related to both cash flow forecasting and disaster recovery – or business continuity – planning, there are some key differences:
- Disaster recovery is about how your business will operate in the immediate aftermath of an unexpected acute event, while scenario planning looks at how a shift in the business environment might affect business performance over time.
- Cash flow forecasting generally predicts future cash flow based on historical data, assuming the future will look similar to the past. Scenario planning looks at unexpected events outside your control that have the potential to change the environment your business operates in.
What is involved in scenario planning?
A key part of scenario planning is identifying the scenarios that have the most potential to impact your business. These will vary based on a number of factors, but there are core principles for what the planning should focus on. These are:
- Plan for scenarios that are at least somewhat likely.
- Plan for the scenarios that are likely to have the most significant impact on your business operations or success.
It can be useful to think about scenario planning in terms of outcomes rather than specific events. For example, rather than planning what to do if the cost of fertiliser increases by 80%, or a conflict breaks out that prevents exports to key markets, think about the most damaging impacts of those events on your business.
“What you can do in scenario planning is consider the numbers,” says Laurie. “Your starting point could be what happens if a customer goes bust, but the scenario you plan for might be what happens if revenues fall by 35%? What if material prices increase? What does that do to our overall margin?”
The benefit of scenario planning
The most obvious benefit of scenario planning is that it increases the chance of your business surviving unexpected events. If you have walked through each step of a potential negative scenario, then you will already have a good idea of the actions to take, and will feel calmer in responding to a real-life scenario and more confident that your business will survive that challenge. Even if the scenario isn't exactly the same as you had planned for, you will still be better prepared and less likely to make poor decisions through panic or a lack of insight.
When the global pandemic hit, UK company Willo saw a huge spike in demand for its virtual interview software. To cope with the spike in growth, the company launched two rounds of fundraising, and investors were keen to see Willo’s scenario planning. “The business environment was very turbulent and scenario planning was critical to our fundraising, but also to our business survival and ultimate success,” says Euan Cameron, Willo’s CEO and co-founder.
Willo's scenario planning focuses on its success factors. “To generate revenue, we must have customers with jobs to fill and candidates to interview. Both of those things are intrinsically linked to economic activity, so most of our scenarios are based around the market and trading environment,” he says.
Willo’s CFO and CEO sit down every quarter with the senior leadership team for a scenario planning meeting. The company prepares key data points such as the previous quarter’s trading and resource utilisation, customer and market trends, and assumptions about future trading conditions.
An important element of scenario planning is considering how the situations you’re planning for might impact your cash flow. This is a vital consideration since most cash flow forecasts assume the future will look like the past, which can provide a false sense of security. As a result, many businesses build alternative cash flow forecasts as part of their scenario planning activity.
How to create alternative cash flow forecasts
Creating alternative cash flow forecasts means predicting how specific scenarios could affect key financial metrics. “If you are anticipating that there is a slowdown in consumer spending, you might use scenario planning to predict the effect that has on unit volume, operating costs, and cash flow,” says Laurie.
The key steps for creating an alternative cash flow forecast are:
- Start by considering which scenario(s) you are planning for. A good starting point is to consider the best-case scenario (rapid growth), the worst-case scenario (rapid decline), and the most likely scenario (modest growth).
- Work through your budget for each scenario. Go through the budget line by line and consider what might happen to each item. Will staff costs rise or fall? Will you benefit from discounts on raw materials? Will you need to take on additional debt or use credit facilities?
- Identify how changes might impact your success factors. How will the potential changes to the budget associated with this scenario impact your business goals? Will the business be able to support rapid growth? Will the projected scenario reduce profitability? Will you have sufficient cash flow?
- Make a protective action plan. With the involvement of relevant stakeholders across your business, identify what pre-emptive changes could be made to protect the company’s cash flow and performance based on your key threats. For example, could operational changes reduce energy costs? Is there scope to move to freelance workers on flexible contracts?
- Review and revise. As external conditions evolve, remember to revisit and review scenario plans regularly – Laurie suggests looking at scenario planning data assumptions monthly, if possible.
Alternative cash flow forecasts are not only important to scenario planning, but are vital when assessing the viability of planned changes in strategy, Laurie says. For example, a business looking to increase cash flow might offer a discount to customers to drive more purchases, without having fully interrogated the numbers.
“If you offer a 10% discount on a product with a 35% margin, you may well need to increase sales by 40% to offset that discount and maintain cash flow,” Laurie says.
“With a 20% discount, you’d need to increase sales by 133%. Those numbers are quite alarming, but doing proper scenario planning means you fully understand the impact of certain actions and changes on overall margins and cash flow,” he says.
