Financial decision-making tools in uncertain times
“In the Chinese language, the word ‘crisis’ is composed of two characters, one representing danger and the other opportunity.”
John F. Kennedy, 1960, Source: JFK Presidential Library
Never in our lifetimes have we seen any event that has affected all countries so rapidly and so drastically – a global health crisis that has turned into a financial crisis. From the Dow Jones to the DAX, major stock exchanges have lost over 30% of their value. Due to lockdowns and uncertainty, consumer spending has declined significantly and continues to do so. In addition, supply chains have been disrupted. All these factors have a major impact on sales, and customers may default on payments.
Economies are experiencing uncertainty and unpredictability. There is uncertainty as to which markets are at risk of collapse, and the magnitude and duration of the crisis is unclear as well. Hence, managers are seeking answers as to what to focus on, and how their businesses can survive all of this successfully.
The role of Financial Planning & Analysis (FP&A) is to support management in this difficult time. The task at hand is to minimize the risks of the current situation while at the same time identifying and pursuing new opportunities. Existing financial tools can be applied to help management to get a clear overview and make informed decisions.
Management needs to understand the drivers of the crisis that are influencing business performance. Through high-level scenario models, the range of financial impacts of the crisis becomes clear. Based on an understanding of the short-, medium- and long-term implications of the COVID-19 crisis, a company can take the right measures. Cashflows should be optimized so that the company can fulfil its obligations and does not default.
Three pillars of FP&A
The following three pillars of FP&A, and the relevant financial tools, are crucial to help a company steer through this crisis:
1) Drivers of the “new normal”
As noted, everything has changed. In order to successfully steer through this crisis, the first step is to identify all the drivers that are currently influencing your business the most. The relevant financial tools are market analysis, high-level analysis of your financial statements (P&L, balance sheet and cashflow), analysis of the top 10 customers and a worst-case scenario.
2) Action items: Reorganization
Once you have identified the most important variables, the next step is to develop a high-level forecast. Based on this forecast, action items can then be defined to optimize resources and costs. The result should be higher liquidity.
Resources can be reallocated to products and departments with the highest revenue potential or to developing alternative channels for sales.
Management reviews costs, prioritizes them and cuts costs which are not necessary. Every euro saved in costs will have a direct positive impact on EBIT.
Good communication fosters the exchange of information and better working relationships during the search for solutions in this crisis. It also ensures that all necessary measures will be understood by both subordinates and peers.
In the following, I will shed more light on each of these three pillars of FP&A and the relevant financial tools in the framework of the crisis.
Drivers of the “new normal”
The drivers of the new normal can be identified using four tools: market analysis, financial analysis, top 10 customers analysis and worst-case scenario.
As noted, FP&A can bring more clarity to this unprecedented situation. To this end, FP&A should gather as much information as possible about the crisis and the influence it is having on the business. Questions to be addressed might be: What path will the pandemic take? What industrial sectors are being affected to what degree? What portion of our business is or will be affected? Have our customers’ buying habits changed or will they change in the future? How is our supply chain being/going to be affected?
Taking a bird’s-eye view, the current situation should be analyzed versus past year and plan. A high-level variance analysis of the financial statements (P&L, balance sheet and cashflow) is conducted.
At this stage, the focus should be on a high-level analysis, as the goal is to identify drivers of the crisis and their financial impacts. Otherwise there is a risk of getting lost in the details and losing sight of the big picture.
It is important to analyze the current situation from both angles, namely versus past year and versus plan. Analysis versus the past shows developments and trends. Analysis versus plan shows which variables have changed compared to the old business environment. The conclusions drawn are the basis for a rolling forecast of the business.
Big variances can be indications of drivers related to the crisis. The cumulative financial effect becomes apparent. The drivers must then be specified further. For example, it must be determined whether a decline in income is due to very low demand, which could be directly linked to consumer behavior related to the COVID-19 crisis.
The next step is to summarize all the major drivers and the current financial impacts. These findings are discussed with management and form the basis of projections and forecasts.
Top 10 customers analysis
After the major causes and the financial impacts have been identified, an income analysis is carried out. This analysis yields insights regarding the degree to which your major customers are being affected by the crisis and how much this will impact your cash inflows.
The focus is on the top 70-80% of your customers by volume (Pareto Principle). Ideally, this should be from around 10 to a maximum of 20 customers. Conducting a similar analysis of the customers generating the remaining 20% of volume would be more time-consuming without adding any significant additional value.
For each of the major customers, information should be obtained as to how much the COVID-19 crisis has affected their businesses and how financially stable they are. Similarly to your own financial analysis, each major customer should be analyzed based on actual income versus past year and plan.
To get a full picture, segmentation and pricing analyses should be conducted to supplement the volume variance analysis. The segmentation analysis shows you the concentration risk of your customer base, the percentage split of your total customer volume and any shift in shares. Actual figures are compared with two time dimensions (past year and plan). The pricing analysis reveals the development in the prices of customers’ products or services.
You will gain a clear understanding of which customers are unstable and therefore at risk for default of payments. Risks can be quantified.
In a worst-case scenario, FP&A calculates how long the company could survive if all sales at risk were to default. This calculation can be based on the top 10 customers analysis performed in the previous step.
The worst-case scenario shows how long the company could sustain operations with the current cost structures and while top customers’ revenues break away.
This is the bottom line of financial stress testing and a starting point for optimizing sales and cost structures in this difficult period.
Action items: Reorganization
Based on the drivers of the crisis and how they affect the company, the next step is to build a roadmap for the coming months.
Based on an in-depth understanding of the financial impacts, the ultimate goal is to optimize cashflows. The roadmap addresses all the challenges identified and defines actions items to mitigate the impact of the crisis.
A rolling forecast based on different high-level scenarios (worst-, real- and best-case) will help to show the
effects of potential measures. Further initiatives can be identified and prioritized.
The forecast is an iterative process and starts with the real-case scenario. Based on the findings so far, a high-level forecast of the P&L statement, balance sheet and cashflow is developed. Action items and cost reductions are identified. The next step is to formulate the details of cost reductions and strategic action items as described below.
The process of working out action items will lead to new insights, making it necessary to adjust the real-case forecast. Finally, a real case should be established. Based on this, a best and worst case can be worked out next.
Based on the rolling forecast, actions items are defined to address the biggest challenges. With the support of FP&A, senior management defines the timelines and resources for, and owners of, the action items.
Efficient cost controlling can optimize cash and increase liquidity. Every euro saved in costs leads to direct positive effects in the P&L statement. FP&A conducts a high-level analysis of accumulated expense accounts versus past year and plan. It then looks at the biggest cash outflow positions and analyzes which investments can be continued and which should be postponed.
In general, there are three major cost categories that require further in-depth analysis and discussions with management:
Salaries: Employees can be reallocated to positions with the greatest revenue streams, therefore optimizing the use of resources. Depending on how badly the company is hit by the crisis, short-time work (government subsidization of salaries) is another option for reducing costs and freeing up cash to cover fixed running costs.
IT: The biggest chunk of IT costs is usually related to digitalization projects. A separate review should be conducted in order to decide which projects should be continued and which can be postponed. Companies should not make the mistake of holding off on all projects without reviewing them. After the crisis, the economy will recover, and companies that remain flexible will have a competitive advantage over other market players.
Marketing: The same approach as with IT should be taken with Marketing. Which projects provide the biggest return on investment and which can be put on hold?
Likewise, production companies should review planned investments in plant and equipment and decide which of the investments should be pursued under the current circumstances.
Negotiations with vendors concerning payment terms and prices will also help to reduce costs and optimize cashflow.
All of these initiatives optimize working capital by expediting receivables and extending payables, which frees up cash.
In summary, companies should not reduce costs without reviewing them, even in difficult times. Investments that provide a clear competitive advantage should be continued if possible.
Last but not least, it is crucial to establish regular communication channels with all stakeholders. Starting with management, FP&A provides stakeholders with various reports and analyses. During this period of crisis, especially, meetings help to ensure that no information gets “lost in translation”.
If FP&A develops reports without the input of management, the reports could easily become superfluous. Conversely, if management makes decisions without the support of FP&A, the risk is that they focus on initiatives that do not add enough value and have low financial impact. FP&A serves as the “financial conscience” of the company and adds value with their analyses, as decisions can be made on a more rational basis.
When decisions are made with regard to employees and investments, they should be communicated in a way that makes them understandable to all employees. Only then can everyone commit and contribute.
For the time being, we can only accept the uncertainty as to how long the pandemic will last. However, FP&A can already begin contributing to the survival of the company now. This framework for financial decision-making will help management to steer the business in this difficult time.