8 Jun, 2023
Learn how scenario planning can help businesses to identify potential risks, stay agile, and build resilience into their growth plans.
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 scenarios into your forecasts.
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What is scenario planning?
Scenario planning is a technique that involves creating a range of possible outcomes for your business, based on different factors that may affect it.
In the context of 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 the projection of 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 in identifying risks, making informed decisions, and preparing contingency plans to respond to different future scenarios.
Why is scenario planning important?
1. It helps you identify potential risks
Scenario planning allows you to consider a range of possibilities, from the best-case scenario to the worst-case scenario. By doing this, you can identify potential risks that your business may face and prepare for them 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 measures to mitigate the effects of these risks, like cutting costs or finding alternative suppliers.
2. It enables you to make informed decisions
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 were to 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.
3. It helps you to stay agile
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.Back to top
Asking the 'what if' questions
In the face of economic uncertainty, businesses worldwide find themselves teetering on the tightrope. It's crucial to ponder the 'what if?' questions.
- 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 the right tool, you can be prepared for any possibility.Back to top
The process of scenario planning
In a recent 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.”
Get all hands on deckTo create a comprehensive and effective plan, involve all departments in the planning process. By bringing everyone together, you can collectively assess the impact of specific targets on your business.
Consider several scenariosUsing a forecasting tool like Fathom to create multiple scenarios with both positive and negative outcomes. For example, what if 25% of your clients stop using your services, or what if they grow by 25%? How will this impact the rest of your business, and how will you work through it?
"Show me the money"Regardless of the scenarios, you need to figure out how to finance them. Cash flow modelling tools, like Fathom, can provide valuable assistance in this regard.
Review your plan regularlyIt's essential to review your actual performance regularly, not just compare it to your budget. Evaluate your performance against each scenario you're tracking. Identify triggers for worst-case scenarios and proactively make decisions based on emerging situations to avoid them.
Examples of scenarios to consider
A recession is a period of significant economic decline, which can lead to reduced consumer spending and a decrease in 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.
Supply chain disruption
A disruption to a company's supply chain can be caused by a variety of factors, such as natural disasters, political instability, or trade restrictions. A supply chain disruption 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 need to be prepared for the possibility of disruption in their industry. Technological disruption can occur through the development of 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 experiences a significant expansion in the target market or customer base. It could be due to factors such as 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 and planning for this scenario, businesses can position themselves to seize growth opportunities and maximize their success in an expanding market.
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Scenario modelling: A retail business example
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 decides to use scenario planning to create a three-way cash flow forecast and identify potential risks and opportunities.
We have provided some 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 to attend more social events. The owner also assumes that there will be no major supply chain disruptions or unexpected costs.
To model this scenario in Fathom, we have taken the underlying rules and plans from the main forecast 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 are expecting 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.
To assist with cash flow, we’ve also planned for a potential loan in the worst-case scenario forecast. This loan can be made active or inactive in the scenario at any time as the actuals are updated in Fathom each month, enabling the business owner to both 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.
Utilising scenarios you’ve created
By creating a three-way cash flow forecast, the business owner can compare the potential outcomes of each scenario and identify potential risks and opportunities. For example, if sales start to recover, the owner may choose to invest in new inventory or marketing campaigns to capitalise on the trend. Alternatively, if sales continue to decline, the owner 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 to be better prepared for the unexpected and make informed decisions about their finances. By considering a range of potential scenarios, businesses can develop contingency plans and make strategic decisions that will help them navigate economic uncertainty and emerge stronger in the long run.
Scenario planning software
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, the scenarios you create are versions of your main forecast and remain connected to it. 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 forecast you create, enabling you to visually compare future forecasts and share your findings with others. You can feel confident in the business decisions you’re making and get buy-in from stakeholders and team members.
Fathom forecasting in practice
For Jarrod Morris of Pitch Labs in Australia, forecasting in Fathom has helped his practice to 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 what the cash flow would look like if the hospitality group were to purchase a new venue, and then also add on 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 is feeling as though they’re needing 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 and then the business can 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, 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, you can ensure that your business can weather any storm.
- Get an overview of Fathom's forecasting feature
- Watch the skill-up series, which guides you through a forecasting process with an advisor using Fathom
- View our product webinars on cash flow forecasting
Questions, comments or feedback? We'd love to hear from you. Get in touch by sending an email to firstname.lastname@example.org.
Written by Georgie Pollok
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.