As finance professionals, one of our biggest challenges is helping organisations prepare for the future. Unfortunately, even the biggest finance departments still aren’t equipped with crystal balls allowing us to see 3, 6, or 12 months ahead of time.
So, for a long time, CFOs and finance teams have used trend analysis to prepare their businesses for the future. In this article, we’re going to show you why Scenario Analysis is a better tool for this challenge. Scenario Analysis is a planning formula that offers a much more comprehensive look into what the future might hold and how you can prepare for the uncertainty.
Trend Analysis: The Backbone of Old School FP&A
“Trend analysis basically says ‘let’s think about the past and let’s take it forward to the future,’” says Bernard Ross, director of The Management Center.
Ross is an international expert in strategic thinking, organisational change, and personal efficacy. He has over 25 years of experience working with non-profit organisations like the Red Cross, Amnesty International, Greenpeace, and more.
Ross explains that the biggest fault with trend analysis is that it assumes the future will look just like the past. “It doesn’t take into account that the world really changes sometimes,” he says.
Due to this assumption, trend analysis leaves a lot of room for nasty surprises. And while it has long served as the backbone of financial planning and analytics, it is far from the best tool finance teams have at their disposal to help companies properly prepare for the future, especially not in today’s uncertain economic climate.
Scenario Analysis: A Comprehensive Look into The Future
Scenario analysis offers a more comprehensive way of planning for the future. Unlike trend analysis, it isn’t so focused on the past and instead encourages your team to think more liberally about what could happen in the future.
“Scenario analysis is a plausible future narrative, or a story, impacting many variables across the organisation;” says Jack Alexander, author and FP&A expert, at one of our webinars on budgeting and planning best practices.
The budgets and other traditional strategic plans in your finance arsenal tend to work by focusing on changes to single metrics like revenue, production costs, or cash flow.
Scenario analysis, on the other hand, works by outlining detailed scenarios and tries to paint a more comprehensive picture of how each scenario would affect the key drivers of your business.
“In the case of contemplating a recession, for example, a Scenario Analysis would take into account the effects the recession has on multiple variables like unit volume, pricing, human capital turnover, compensation, and more,” says Jack Alexander.
In doing so, scenario analysis provides a much deeper insight into your company’s performance and how it might be affected by complex, real-life situations.
Best Practices for Incorporating Scenario Analysis into Your Planning Processes
Incorporating scenario analysis into your planning is vital. However, it can be challenging for financial planners to understand just how to implement this strategy properly.
It’s all well and good to brainstorm a bunch of potential scenarios, but how do you know which ones are actually focusing and how to prepare for them adequately?
Well, we recommend starting with a base case. This can be the scenario that seems most likely based on trend analysis. Make sure to clearly identify the key assumptions leveraging this projection, and also outline how it would affect all of your company’s key drivers.
Next, you’ll want to start brainstorming other potential scenarios. To do so, it helps to work with a multidisciplinary team of people, not just members of your company’s finance team.
For each of these new scenarios, you’ll then want to:
- Provide a clear description of the event and the likelihood of it happening.
- Highlight the impact the scenario would have on your company’s key drivers.
- List some key indicators of the event occurring.
- Highlight a clear trigger event that marks the event is about to take place.
From there, you and your team will want to prepare detailed management responses for each scenario. It’s critical that, for each of these scenarios, you outline what actions your company should take before, after, and at the time of the trigger event.
Remember, there’s likely no shortage of scenarios you and your team can come up with. To maximize your resources, some FPA experts suggest medium-sized businesses stick to brainstorming only 3-4 scenarios. Shell, on the other hand, encourages leaders to stretch their thinking and even consider scenarios that might seem only remotely possible.
We believe that the number of scenarios you prepare for depends largely on the size of your organisation, its scope, and resources. In general, we recommend spending less time on the best and worst-case scenarios, as they tend to be very obvious and don’t really encourage your team to think outside of the box.
For more tips on how to help your company prepare for the future, check out our webinar on Budgeting and Planning Best Practices and bookmark our blog for more content like this.