The Importance of Scenario Analysis in Financial Planning
You’ve built a budget and regularly update your forecast of full year results. Great. Now you should add conservative and aggressive forecast scenarios.
Companies of every size, but especially startups, should regularly update their financial forecast, at a minimum for the rest of the fiscal year, but even better on a rolling 12 months forward-looking forecast.
It’s also a good idea to add additional forecast scenarios that answer ‘what-if’ questions. What will you do if bookings come in less than expected? What if churn increases and cash flow is reduced? Or what if bookings really soar? How should we re-invest that windfall into future growth?
A common trap with scenarios is to simply add or subtract 10% or 20% or whatever to revenues and see how the numbers change. That results in new information and maybe a couple extra slides for the Board deck. But did it really do you any good? To truly capture the power of scenario analysis, you have to run the mental exercise of putting yourself in that moment. In real life, when you see revenue or new bookings drop significantly below your budget, you will have to take actions at that time.
To truly capture the power of scenario analysis, you have to run the mental exercise of putting yourself in that moment.
Try to think through those actions in advance. Will you slow down hiring, maybe a hiring freeze, or even more draconian expense actions? Yes, of course you will, so add that into the conservative scenario. Even better, make a list of the triggers and the actions and when you will take those steps. Set realistic triggers that determine when an action must be taken, and commit to actions that change the expected financial outcome.
Set realistic triggers that determine when an action must be taken, and commit to actions that change the expected financial outcome.
What you are starting to create is a conservative scenario plan.
Here’s a good example:
Suppose your base case budget is to add $10 million in new Annual Recurring Revenue (ARR) in the next year, or $2.5 million per quarter. You have built expense budgets and hiring plans that, paired with that revenue growth, get you to a break-even cash flow for the year. You set $7.5 million as a conservative new ARR case. That means you need to take out $2.5 million in expenses to hit the same break-even cash flow goal. Of course, you won’t have that perfect information on Day 1 of the year; it’ll take at least a quarter to realize your conservative case is now more realistic. And so you have to make those same $2.5 million in expense reductions but in the remaining nine months.
Set Realistic Triggers and Actions
Downside Trigger / Action Example:
An example trigger could be that by the end of quarter 1, you see only 75% of your $2.5 million quarter new ARR goal. In the scenario you will take the actions to 1) reduce discretionary marketing spend by x%, 2) implement a hiring freeze, and maybe 3) reduce travel budgets, all effective on day 1 of the second quarter. To make the scenario a truly powerful plan of action, you should actually write those actions down and make a commitment as to when those decisions will be made.
If you don’t write down those triggers and actions, then your conservative scenario is just a bunch of numbers on a page. Better yet, devote a page of these triggers and actions in your Board materials.
Upside Trigger / Action Example:
The same is true in the upside or aggressive case. What will you do with the windfall? There are many right answers to this. You could step on the gas with marketing spend to invest in future revenue growth, accelerate R&D activities, or pay down debt. But probably not all three. It is an equally useful exercise that when you prepare this financial scenario that you write down your plan of what you will do, and when you will do it.
Scenario analysis is a powerful tool in planning how to use an entity’s scarce resources. But without accompanying triggers and actions you’ve just made your spreadsheet 3x more complicated for no good reason.
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