In 1789, Benjamin Franklin famously penned the words, “In this world, nothing is certain except death and taxes.” But that was more than two centuries ago. If Franklin were alive today, he might have added “volatility” to his well-known adage.
The global economy of 2021, buoyed by pent-up demand and extremely loose monetary policy, produced staggering statistic after staggering statistic. In nearly every category of economic data (stock market, housing market, corporate bond market, IPO volume, M&A activity), new records were constantly being set.
Now, the macroeconomic pendulum is beginning to swing in the opposite direction.
All across the globe, workers and consumer goods are in short supply, but there is a surplus of uncertainty. High inflation is compressing the profit margins (and stock prices) of businesses in nearly every industry. In an attempt of central banks to reign in high inflation, tighter monetary policy is making it much more expensive for businesses to access capital markets, either through new debt issuances or IPOs. Those As a result, 2022 is on pace to become the weakest IPO market in two decades. Mergers and acquisitions (M&A) volume has also experienced a precipitous decline.
Those higher interest rates make it much more difficult for highly leveraged consumers, businesses, and governments to service their debt, leading economists to predict a recession in 2023.
Most recently, the rising value of the US dollar presents a significant foreign exchange risk for corporate treasurers, as billions of dollars have been erased from the earnings of multinationals. Now, treasurers must develop more creative currency hedging strategies. New business challenges seem to be more frequent and arrive without warning.
After the 2008 financial crisis and subsequent recovery, economic stability became the rule instead of the exception. Inflation remained low, growth remained high, productivity soared, and financial markets thrived. These last few years have been a reminder that stability is fragile, and volatility is never more than a crisis away. In this environment, scenario planning has become essential for finance leaders to navigate through the uncertainty. There are three areas that scenario planning should focus on:
When assessing and optimizing financial health, liquidity is a great place to start. The most critical questions to answer include:
In the near term, these are arguably the most important financial questions to be answered. With liquidity comes options: excess cash can be used for capital expenditures, strategic projects, or perhaps to capitalize on the next M&A opportunity.
Capital structure is another crucial area that has long-term consequences for business performance. The most critical questions to answer include:
Capital structure should be constantly fine-tuned and readjusted to reflect external risks and economic shifts. Adjusting capital structure is a decision that shouldn’t be made lightly, as it has profound implications for future financial performance. Leverage can amplify earnings, but it can also magnify losses. In a time of high interest rates and high inflation, businesses may want to de-leverage to minimize risk and maximize financial strength.
The business model should be re-examined and stress-tested to reveal any potential underlying weaknesses. The most critical questions to answer include:
Running profitability scenarios is crucial, especially when considering changes to the business model, employee wage compensation, or product pricing. Evaluating financial impact prior to mergers, acquisitions, and divestitures is equally important. This allows finance leaders to analyze potential funding options for the deal, as well as how that might affect profitability, capital structure, working capital, leverage, and cash flow.
By constantly scrutinizing the business model and stress-testing growth plans, businesses can predict future financial health with a higher degree of confidence. By modelling the impact of strategic scenarios across the balance sheet, income statement, and cash flow statement, CFOs can make better decisions—faster.
No matter the challenges your business will face in the days ahead, scenario planning equips your business with the tools it needs to be successful.