Have you ever heard your business partners complaining to your finance team? Your forecast is “too aggressive” or your forecast is “not realistic?” or even worse, that your forecast is “wrong”? are the most common objections.
If you are looking for a solution to this problem, then please continue reading this article.
‘Forecasting’ is assessing the company’s performance over a set period in the future. Although, the role of FP&A requires predicting the future financial performance. FP&A teams are not fortune-tellers (they wouldn’t be working in FP&A if they could tell the future accurately to be honest!). This is where scenario planning comes to the rescue.
Although, the role of FP&A requires predicting the future financial performance. FP&A teams are not fortune-tellers
“Scenario planning” is the practice of establishing different possibilities based on various sets of assumptions.
According to the Corporate Finance Institute, “Scenario analysis is a process of examining and evaluating possible events that could take place in the future by considering various feasible results or outcomes.
Finance typically does the 3 basic scenarios :
1. Base case scenario : This is the most likely outcome. Also, in most cases it is the average outcome of all possible assumptions.
2. Best case scenario: This scenario assumes we will be hitting all green lights or the most optimistic scenario.
3. Worst case scenario: This scenario considers the most pessimistic outcome assuming everything that could go wrong actually goes wrong.
Why should you perform Scenario Analysis?
It is always better to take care of a problem does not arise than to have to solve the problem afterwards.
i) Avoiding risks and failure : As the popular saying goes ” Precaution is better than cure ” It is always better to take care of a problem that does not arise than to have to solve the problem afterwards. Scenario analysis helps you avoid making poor decisions. By accounting for the best and worst case scenarios senior management can make better informed decisions.
ii) Planning and Budgeting: It gives senior management a sneak peek into the expected results when planning for various possible outcomes.
How to Perform Scenario Analysis?
1. The first step is to list all the key assumptions for a given event.
2. Next, for each assumption, consider the three outcomes : the best case, the worst case and the most likely.
3. Use probabilities to arrive at weighted outcomes for each of the assumptions.
4. Aggregate the weighted outcomes for each of the 3 scenarios.
5. Review and update at regular intervals. Keep looking for any signals of change to the assumptions or to the earlier estimated probability of occurrence.
Scenario analysis is an important aspect of the planning and forecasting exercise. And improved scenario planning capabilities will help the finance teams to help drive the business