Analysts expect the soaring dollar, falling oil prices and expected volatility in the stock market in 2015 to wreak havoc on corporate earnings. The external shocks illustrate just how important it is for companies to come up with more than just one scenario for planning—and even more than just a best-guess, worse-guess case. The increased volatility is pushing more companies into practicing what experts label risk-adjusted forecasting.
At its most developed level, “risk-adjusted forecasting shocks cash-flow and earnings at risk metrics by introducing major risk factors to these drivers and then generating a corresponding probability distribution for each reporting period,” said Charles Alsdorf, director at Deloitte.
That does not mean the models have to be very complicated. “You can build it in Excel and use Monte Carol simulations to look at individual risks as well and risk combinations and their impact on the forecast,” said Alsdorf’s colleague, H-K Bryn, strategic risk partner at Deloitte in the UK. “You set up the risks and the relationship between them and identify at what level of the financial statement they would have an impact.”
However, more advanced technology is now becoming available in many ERP systems to allow companies to incorporate firm-wide processes when running the analysis. “It makes life more complex but significantly more insightful,” Bryn said.
“Many risks are external to the organization and are hard to quantify,” noted Steve Player, managing partner of the Player Group, and program director for the North American arm of the Beyond Budgeting Roundtable (BBRT). What works is for the risk management function to identify those risks and how the company can take advantage of the upside or protect the organization from the downside. “You need to take those elements and include them in the planning process,” he said.
How can companies implement a more advanced form of forecasting? By following these risk-adjustment best practices:
- Start small and build up capabilities over time can sometimes help create buy-in from senior management because incremental benefits can be demonstrated.
- Get management buy-in by showing early wins.
- Select only a small set of risks at first and integrate them into the normal course of FP&A.
- Use a specific transaction to test this can make the paybacks clearer because they are more immediate and they tend to get the attention of everyone in the company (e.g., large CapEx investment, acquisition or divestiture)
- Incorporate multiple risks into the forecasting process; look at the interaction among those risks, since risk rarely happens in isolation.
- Create scenario analyses to come up with different risk and opportunity outlooks based on a list of key risks facing the organization.
- Use qualitative approach when modeling is difficult or not available.
- Run pre-mortem analysis to help create contingency plans.
- Integrate risk management and FP&A.
- Plan on a long term implementation. This is not an overnight transformation.