After years of economic expansion, we’re finally seeing the tide turn again as we enter what looks like it will be an extended recession. When you consider the impact of the pandemic, widespread inflation, war in Ukraine, and supply chain issues across the board – this is not something that should surprise us. But if you haven’t been paying attention and considering the impact of a recession on your business, you might find yourself in that position.
Robust businesses are able to weather recessions because they evaluate the implications and make proactive decisions that protect their downside and manage their risk appropriately. The way that you do this is through scenario stress-testing.
What is scenario stress-testing?
We can never fully know the future. But we can plan for various eventualities so that we have a couple of plans up our sleeves. That’s what scenario stress-testing is all about. We take a view on several assumptions about our business and the macro-economic environment and then we forecast what that will do to the financials of our organization.
For example, to test a recession we might lower our demand, increase the cost of borrowing, forecast supplier challenges, and other negative impacts to see if our business can still withstand all of it. When we look at the results of the scenario stress-testing we will have a better sense of how robust the company is and if the results are concerning we can make changes upfront to avoid getting there.
While recessionary scenario tests are negative, it’s worth mentioning that you can do positive scenario tests as well – to see what impact an increase in marketing or a decrease in customer acquisition costs might do. But for now – we’re just going to focus on making it through the challenging times we find ourselves in at the moment.
How to do effective scenario stress-testing
There are a few key pillars to focus on when doing your scenario stress-testing:
- Look at historical precedent. A good place to start is by analyzing past recessions and seeing how your business fared. If sales went down by 25% then that’s a decent benchmark to use for your assumptions in the scenario test. This grounds the tests in reality and helps you get a more accurate picture.
- Prepare for the unexpected. In contrast to the above, you also want to run scenario tests where the results far exceed what we’ve seen in the past. The idea is to stretch the bounds of reality and see where your business breaks.
- Run a number of tests. Because we don’t know how things are going to unfold, you’ll want to run several scenario tests that capture various outliers – so that you can understand the terrain more holistically. It’s in the combination of these tests where you find the value.
- Document your results. Once you’ve run each test, it’s important to spend time analyzing the results and then document the insights that you’ve discovered. Your notes and plans coming out of this process are what you’ll actually act on when the time comes – so careful documentation is an absolute must.
- Consider interdependent variables. Companies are often tempted to change one variable and then call that a realistic test, but the truth is that everything is interconnected. Consider the fact that a change in one variable will have indirect impacts on others – and strive to incorporate those in your testing so that you have a more accurate picture.
These are just a few of the things to consider when doing your scenario stress-testing. And right now, this is something that should be top of mind if you want to weather the recession to come.
To help you accomplish this, Apliqo’s suite of FP&A tools is perfectly suited to these sorts of tasks. You can easily change dynamic variables and drivers and the platform will roll those through your entire financial system to help you understand the impact. You can then visualize those effects in a holistic way that aligns your financial performance with your short and long-term strategy.
If this sounds of interest, be sure to get in touch today and let us show you how regular scenario stress-testing can significantly improve your planning through good times and bad.