June 8, 2023
Running a business is like walking a tightrope – one misstep can lead to quite a tumble. That’s why it’s essential to have a clear understanding of your finances, especially your cash flow, to make sure you can keep your balance during tough times. One effective method for managing your cash flow is to build scenario planning into your forecasts.
Learn how scenario planning can help businesses to identify potential risks, stay agile, and build resilience into their growth plans.
Scenario planning is a technique for creating a range of possible outcomes for your business based on different factors that may affect it.
In three-way forecasting, scenario planning refers to creating multiple scenarios or projections for a business's financial future based on different assumptions and variables, such as sales, expenses, market conditions, and external influences. Three-way forecasting typically includes projecting a company's profit and loss (P&L) statement, balance sheet, and cash flow statement.
Forecasting and modelling are essential parts of the financial planning and analysis (FP&A) process which supports a business’s financial health, and links strategy to execution.
Scenario planning in three-way forecasting enables businesses to assess the impact of various factors on their profit, cash flow, and overall financial health, allowing them to make more informed and strategic decisions for the future.
By developing multiple scenarios, businesses can gain a more comprehensive understanding of the potential range of outcomes and evaluate the financial implications of each scenario. It helps identify risks, make informed decisions, and prepare contingency plans to respond to different scenarios.
Scenario planning allows you to consider a set of scenarios, from the best-case likely scenario to the worst-case scenario. Doing this lets you identify potential risks your business may face and prepare accordingly. For example, you might consider what would happen if your sales were to drop by 10% or if a key supplier were to go out of business. Armed with this knowledge, you can take steps in your business strategy to mitigate the effects of these risks, like cutting costs or finding alternative suppliers.
When you create a range of scenarios, you can test different assumptions and see their impact on your cash flow. This can help you make more informed decisions about your business. For example, you might consider what would happen if you launch a new product line or expand into a new market. Then, you can see how these decisions would affect your cash flow, which helps you make a strategic choice about whether to proceed.
One of the most significant benefits of scenario planning is that it helps you to stay agile. Considering a range of scenarios helps you prepare for different eventualities and respond quickly if things don't go according to plan. This adaptability is particularly valuable during uncertain times, such as recessions or pandemics. With a range of scenarios at your disposal, you can swiftly adapt your business and outpace the competition.
In the face of critical uncertainties in the economy, businesses worldwide find themselves teetering on the edge of a tightrope. Pondering the 'what if?' questions is crucial.
• What if interest rates continue to rise?
• What if I can’t hire the staff required to run my business?
• What if a key supplier goes into liquidation?
Questions like these can spark fear, panic and uncertainty. But armed with the right approach and tool, you can be prepared for any possibility.
In this article in the Harvard Business Review, author J. Peter Scoblic reminds us that “preparing for the future demands constant reappraisal. Strategic foresight— the capacity to sense, shape, and adapt to what happens — requires iterative exploration.”
But where do you even start? Here are four tips from financial expert David Harreveld, founder of Ascern Advisers, to help you start planning for your business's future.
A recession is a significant economic decline, leading to reduced consumer spending and decreased demand for goods and services. In a recession, businesses may need to consider cost-cutting measures, such as reducing staff or consolidating operations, to maintain profitability. Scenario planning should include a range of potential recession scenarios, including mild, moderate, and severe downturns, to help businesses prepare for the worst-case scenario.
A disruption to a company's supply chain can be caused by various factors, such as natural disasters, political instability, or trade restrictions. It can lead to delays in product delivery, increased costs, and reduced profitability. Scenario planning should include a range of potential supply chain disruption scenarios, including delays in product delivery, shortages of raw materials, or the loss of a key supplier.
The rapid pace of technological change means that businesses must be prepared for possible disruption in their industry. Technological disruption can occur through developing new products, new business models, or changes in consumer behaviour. Scenario planning should include a range of potential technological disruption scenarios, such as the emergence of new competitors, changes in consumer preferences, or the introduction of new technologies that make existing products or services obsolete.
In this scenario, your business environment changes due to a significant expansion in the target market or customer base. It could be due to successful product launches, effective marketing campaigns, or entering new geographic regions.
This expansion leads to a surge in sales and revenue, providing opportunities for scaling operations and capturing a larger market share. In this scenario, businesses can explore strategies to capitalise on the growing market demand. This may include expanding distribution channels, strengthening partnerships, investing in research and development, or enhancing customer experience. By envisioning possible futures like this, business planners can position the organization in ways that seize growth opportunities and advance their success in an expanding market.
Let's consider a small retail business that sells clothing and accessories. The business owner has noticed a recent drop in sales due to economic conditions. To prepare for the future, the owner uses scenario planning to create a three-way cash flow forecast and identify potential risks and opportunities.
We have provided some cash flow forecast examples showing how the business owner may choose to forecast best-case and worst-case scenarios in Fathom.
In the best-case scenario, the business owner assumes that sales will gradually recover over the next year as people continue to return to work in a physical location and start attending more social events. The owner also assumes that no major supply chain disruptions or unexpected costs will exist.
We have taken the underlying rules and plans from the main forecast to model this particular scenario in Fathom and made some adjustments. The owner is planning for additional hires due to the expected increase in sales, so we’ve focused on expanding the sales team in the best-case scenario.
To forecast revenue, we can base future revenue on the average sales revenue of the previous 12 months, allowing us to include seasonality as well. Because we expect sales to recover month over month, we’ve also forecast a 3% increase in sales revenue each month.
In the worst-case scenario, the business owner assumes that sales will continue to decline over the next year due to tight economic conditions and a drop in consumer spending. The owner also assumes that there may be supply chain disruptions or unexpected costs, such as a sudden increase in the cost of raw materials or shipping fees.
As our scenario is based on the main forecast, we have included a 6% increase in the Cost of Sales baseline to account for the potential raw materials and shipping increases.
Because the owner is not expecting an increase in sales, we have not planned on hiring additional sales associates. Instead, new hires are focused on marketing and inventory management. The business owner can change the timing of these new hires on the Business Roadmap at any time, enabling them to plan for and respond to changing inventory and sales conditions
We’ve also planned for a potential loan in the worst-case scenario forecast to assist with cash flow. This loan can be made active or inactive in the scenario at any time, as the actuals are updated in Fathom each month. This scenario analysis enables the business owner to proactively plan for a cash flow loan and respond as economic conditions change.
Finally, to account for the potential decrease in sales revenue, we have forecast future sales revenue based on the average sales revenue of the previous 12 months, with a month-over-month 3% decrease.
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By creating a three-way cashflow forecast, the business owner can compare the potential outcomes of future scenarios and identify potential risks and opportunities. For example, if sales recover, leadership may invest in new inventory or marketing campaigns to capitalise on the trend. Alternatively, if sales continue to decline, business leaders may need to reduce costs or find new revenue streams, such as selling online or offering delivery services.
Overall, scenario planning can help businesses like this one better prepare for the unexpected and inform strategic thinking about their finances. By considering a range of potential scenarios, businesses can develop contingency plans and make strategic decisions to help them navigate economic uncertainty and emerge stronger in the long run.
Fathom is a powerful platform for three-way cash flow forecasting, management reporting and financial analysis. Fathom forecasting empowers business owners, CFOs and accountants to build robust and accurate forecasts in record time. You can quickly see the impact of decisions on your key metrics, like your cash position.
Fathom allows you to flexibly and proactively plan for future possibilities. In Fathom, your scenarios are versions of your main forecast and remain connected. As your main forecast updates with new actuals each month, so do your scenarios. Your scenarios stay relevant over time, so you can count on them being up to date when facing a tough financial decision, changing timelines, or a new business opportunity.
In a Fathom report, you can report on the scenarios and main forecasts you create, enabling you to visually compare future forecasts and share your findings with others. You can feel confident in your business decisions and get buy-in from stakeholders and team members.
For Jarrod Morris of Pitch Labs in Australia, forecasting in Fathom has helped his practice build confidence around decision-making.
“There’s a hospitality group that we work with and initially Pitch Labs was engaged to support with the build of a three-way cash flow forecast to supply to the bank.
“Previously we’d used a convoluted Excel model that was quite onerous to update and, obviously, took a lot of time to create as well. But now we’ve moved to Fathom for our three-way forecasting, which allows us to roll out updated projections quickly and easily build different scenarios, too.
Jarrod and his team were able to model the cash flow if the hospitality group were to purchase a new venue and add in the scenario of a continued rise in interest rates.
“In hospitality, there are other scenarios we’re also looking at, like the increase in the cost of goods sold. That speaks to the macroeconomic environment that we’re operating in. Another big one is payroll because competition for hospitality staff is hot at the moment. Our client feels they need to pay above-award wages to attract and retain key employees.
“So, you’re getting an increase in wages that’s higher than inflation, coupled with supply chain pressures impacting cost of goods sold. And then you add onto that rising interest payments across their debt facilities."
Jarrod uses Fathom to build out a scenario with these external factors. The business can then ask questions like, ‘What might happen if we increase prices in our venues by 5%?’ They can consider what kind of impact this might have and potentially choose to increase prices by a higher margin in city venues than in regional areas.
“They have such confidence now in moving forward with things like acquisitions because they can clearly see the impact on the wider business and on the future cash position. That’s the power of Fathom and the way the software just visualises the financial data.”
Scenario planning is an essential tool for businesses that want to stay ahead. By creating a range of scenarios, you can identify potential risks, make informed decisions in your strategic planning, and stay agile in a changing environment. If you're not already using scenario planning, now is the time to start. By preparing for the unexpected, your business can weather any storm.
Hope for the best, plan for the worst. Be prepared for anything in between. Learn more about scenario-based planning with Fathom's cash flow forecasting software.
Georgie leads our Brand & Communications team. As one of the company’s first employees, Georgie is passionate about the product and its users. She has over 15 years of experience in communications in a variety of industries and holds a Bachelor of Business/Bachelor of Arts in Marketing and Public Relations.
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