In times of uncertainty, scenario analysis and planning are critical tools. COVID-19 presents an extraordinary level of uncertainty. Management accountants are often tasked with estimating the impact on our organisations and taking action in response to the pandemic.
Whether evaluating and projecting financial earnings, estimating cash flow and liquidity, or developing a range of mitigating actions, scenario analysis is not simply a financial planning tool; it is an integrated approach that can assist enterprise-wide efforts in dealing with uncertainty.
That is especially important now. COVID-19 and its impact on organisations of all types is sure to be significant. However, because of its very novelty, the following questions, which will resonate with organisations for years, cannot be answered with high confidence:
- How fast will the virus spread?
- How severe is the virus, including hospitalisation and mortality rates?
- How long will the pandemic last?
- How successful will mitigating strategies be in limiting and containing the impact of the virus?
Scenario analysis provides a structured way to identify a range of potential outcomes and estimated impacts and then identify and evaluate potential actions. It reinforces the presence of uncertainty and increases readiness to deal with a variety of potential outcomes. It also creates a sense of confidence by having a structured way to work through the challenge as it evolves. Scenario planning encourages us to react to the important factors we have identified and to not overreact to extraneous reports or data points.
Why is scenario analysis so critical now?
In general, most operational plans and financial projections are based on a single course or scenario, often not explicitly identified. Single point projections and scenarios have serious shortcomings.
First, they ignore the presence of uncertainty and limit consideration of contrarian points of view. Second, they contain dozens of assumptions, and many of these are critical and implicit — buried in the mechanics of our models. As such, some of these assumptions have not even risen to conscious consideration. They also provide a false sense of security, implying that we have a clear view of future events, and ignore a key truth: The future will be different than we anticipate.
Utilising scenario analysis addresses those shortcomings and has a number of important benefits. It reinforces an organisation’s awareness of uncertainty and provides a range of possible outcomes (scenarios). It also encourages developing deeper insight into critical drivers and assumptions and increases our readiness for a range of potential outcomes. This insight will be increasingly important moving forward.
Key elements of scenario analysis
A scenario is a possible future narrative (a story). A “story” will typically impact a number of variables/drivers; for example, a recession scenario would likely impact a number of performance drivers including unit sales volume, pricing, cost of materials, human capital turnover, and compensation. Scenario analysis will estimate the total impact of the “story” on a firm and encourage the development of a response.
Scenario analysis utilises a number of tools and concepts that are relevant to COVID-19. These include identifying potential scenarios, critical assumptions, leading indicators, and potential mitigating actions. The following examples highlight ways that finance professionals can look at COVID-19.
Identify potential scenarios
Given the level of uncertainty, we need to identify and contemplate a variety of potential outcomes. In areas where the virus is in early phases (eg, in many regions of the US), there are several possible scenarios:
- The initial actions taken by local, state, and federal governments and related behavioural changes (social distancing and sanitation) result in curtailment in the near term, allowing a return to near normal within 15–45 days.
- Precision measures scenario: The initial actions taken by local, state, and federal governments and related behavioural changes (social distancing and sanitation) result in significant curtailment in the near term, allowing a modified approach to target specific activities, regions, population segments, etc.
- The initial actions taken by state and federal governments and related behavioural changes (social distancing and sanitation) result in midterm curtailment, allowing a return to near normal within 45–90 days.
- The initial actions taken by state and federal governments and related behavioural changes (social distancing and sanitation) do not result in curtailment, preventing a return to near normal for 90–120 days.
- Other variations: Medical testing and treatments (including pharmaceuticals) significantly mitigate the virus’s impact.
- Worst-case scenarios: The pandemic cannot be controlled over the next several months.
Scenario 6 is an example of an important principle in scenario analysis: Don’t ignore low-probability, high-impact scenarios. Some consideration should be given to the possibility of that outcome, however improbable.
Visuals are useful in understanding and communicating potential scenarios and related outcomes and mitigating actions. Visuals like the following are especially helpful in identifying critical decision points and indicated actions.
Identify critical assumptions
Each scenario requires dozens of assumptions, including health and economic/business. Nearly all of these assumptions are based on past experience with similar contagious diseases or crises, but each has a high degree of uncertainty since this is a new and unique virus. A few examples:
- How transmittable is the disease?
- What is the impact of social distancing and other actions taken on the spread of the virus?
- How many patients will need critical hospital care?
- What treatment options are (or will become) available?
Economic and business assumptions
- What effect will this have on employment?
- How will this impact our customers and our revenues and collection periods?
- How will this impact our supply chain?
After identifying scenarios and assumptions, we can create a script of how each scenario would play out. We can then model various scenarios, identifying leading indicators, critical decision points, and potential responses.
Create a robust model
Whether we are projecting the impact on revenues, earnings, GDP, cash flow, or hospital loads, scenario planning requires a robust model to estimate the outcomes under different scenarios. Infectious disease specialists employ models to estimate the spread of the virus, required hospitalisations, and mortality. Finance professionals need a robust model to estimate the outcome on revenues, earnings, cash flow, and liquidity.
- Assumptions must be explicitly identified so they can be evaluated and flexed.
- The model must be robust, facilitating sensitivity and scenario analyses.
- Outcomes on key measures (eg, cash flow) must be auto-generated by the model to facilitate impact analysis and presentation.
Track assumptions and leading indicators
How are events and trends tracking our assumptions? Do the trends increase the probability of one scenario’s occurring over another? As more information becomes available (eg, rate of spread), the scenario model can be updated to refine existing scenarios or generate additional possible outcomes.
Identify indicated actions under each scenario
The purpose of scenario planning goes well beyond simply estimating the impact of each potential scenario. The real benefit is realised when leaders identify and evaluate potential actions indicated in each case. In some cases, the actions are indicated under all scenarios. For example, the decision to encourage social distancing and hygiene practices has little downside or cost and will help under any scenario. These actions, called “no-brainer” or “no regrets” by scenario planners, have little downside. Another example would be to facilitate employees’ ability to work remotely from home.
Many actions can be deferred until more information is available. For example, should we close schools for the rest of the year? Subject to other considerations, we can close schools for 15–30 days and then re-evaluate later when more information is available.
Prepare to pivot to normalcy
In dealing with a crisis like COVID-19, our thinking and planning become dominated by “recency bias”. We are so focused on the current news cycle and our response to the crisis that we are not thinking about the inevitable return to a state of normal activity. What event(s) will trigger the restart? How will we reopen? What measures must be taken to sanitise facilities? How will our customers restart? When and how will we bring back employees? What critical supplies do we need to reopen? What cash is required to accomplish this? While it may be difficult to focus on this future event now, doing so will allow us to identify critical issues and actions that facilitate the restart.
Lessons for the future
Even before the outbreak of COVID-19, we were living in a period of rapid change and great uncertainty, including economic cycles, election outcomes, trade wars, and disruptive technologies. Finance and accounting professionals should identify lessons learned from this crisis, including the adoption of scenario planning as part of ongoing efforts in developing plans and projections.
— John “Jack” Alexander, CPA, is an experienced CFO and operating executive turned adviser, author, and lecturer based in the US. He provides advice on strategic and operational planning, forecasting, and financial planning and analysis and is the author of Financial Planning & Analysis and Performance Management, Wiley, 2018. To comment on this article or to suggest an idea for another article, contact Drew Adamek, an FM magazine senior editor, at Andrew.Adamek@aicpa-cima.com.