The following is a guest post from Dave O’Brien, chartered professional accountant and senior engagement manager at Sapling Financial Consultants. Opinions are the author’s own.
Businesses are worried about the impact tariffs will have on their business. In speaking with business leaders, many speak to the challenges uncertainty is causing. Without knowing the full extent of tariffs, what goods will be impacted and by how much, it’s challenging to know the full impact on their business. That is where financial model stress testing becomes essential to help finance leaders understand how best to respond to market uncertainty.
Stress testing: What it is and why it matters for markets and businesses
Financial model stress testing is the process of adjusting and re-running financial models to assess the financial impact of various internal or external factors, such as shutting down a plant or the loss of a key customer. In the context of tariffs, the impact could be the loss of international customers or increased import costs on goods subject to them.
Conducting stress testing with a financial model allows business leaders to run multiple scenarios to evaluate the impact of various levels of tariffs and quantify the impact on earnings, liquidity and cash flow. Decision-makers can then take that understanding to help them make informed decisions on how best to respond. Overall, the main purpose of stress testing is to incorporate all available information into forecasts to enable decision-makers to make surgical, rather than blunt, changes to the business to preserve resources and capacity and best position it to emerge from the trade war as unscathed as possible.
Stress testing has the added benefit of helping to build support for planned changes with key stakeholders, such as board members, investors, lenders, or employees. Supporting planned decisions with a strong, well-reasoned rationale will be more successful than relying on gut feel and intuition.
Incorporating scenario analysis in stress testing models is a way to assess performance under multiple conditions. At a minimum, it is recommended to develop three broad scenario categories:
- Base case. This takes what your business operations would have been had the crisis not occurred. Ideally, it’s from a model that has already been run by your investors and lenders. This will help with understanding deltas in their expected returns while also offering a baseline for what a future recovery may look like.
- Stressed Case (without mitigants). This scenario starts with your base case and then reduces revenues based on revised expectations in light of the COVID-19 crisis. What you don’t do in this scenario is build in any mitigants, such as layoffs or loan arrangements. This scenario will estimate the largest cash shortfall possible for the worst-case scenario. You can have several versions of this scenario based on different shutdown lengths and revenue reductions.
- Stressed case (with mitigants). Finally, in this scenario, you start with your revenue forecast from the stressed case (without mitigants) and then layer in mitigants like layoffs and other cost-cutting methodologies to demonstrate what the expected cash profile looks like. As with the stressed case (without mitigants), you can run several versions based on different shutdown lengths.
Looming tariffs: Market impact and strategies for mitigation
Tariffs can negatively impact business performance by reducing demand in foreign markets and increasing the cost of importing goods. This effect is felt across various industries, from energy and automobile manufacturing to agriculture and food. However, companies facing tariffs are likely to encounter similar challenges, such as:
- Declining sales: Passing tariff costs onto customers through increased prices will likely lead to decreased sales.
- Changes in pricing structure: Adjust pricing if the full impact of tariffs cannot be passed on to consumers. Discounting may help drive sales volume.
- Increased costs: Expect increased costs for supplies, especially if sourced from the U.S., which can pressure margins.
- Cash flow challenges: Focus on short-term forecasts to assess cash positions and secure short-term financing for potential liquidity shortfalls.
While the challenges are likely similar across companies, the extent of the impact and the necessary mitigating responses available are likely to be different. To preserve cash and earnings, companies can consider several courses of action, such as the following:
- Increasing domestic sales efforts
- Renegotiating with or finding new vendors
- Stretching accounts payable days to preserve cash
- Seeking out new forms of financing
- Personnel layoffs
- Closing underperforming or redundant plants, warehouses and/or offices
A detailed and dynamic stress-testing model allows users to incorporate both the impacts and the responses above into a revised forecast to anticipate financial performance across multiple scenarios, tweaking the extent of mitigating actions required to ensure the business can maintain cash flow.
Data and analysis outperform gut feeling
When faced with any challenging business decision, it’s best to approach it with facts and analysis rather than gut feeling. Economic uncertainty specifically can be challenging for firms because uncertainty makes it difficult to quantify the impact.
Stress testing can be an invaluable tool for businesses by enabling them to gauge the impact of various economic shocks, quantify the extent of mitigants required, and then analyze their business for the impact of those mitigants. Overall, a well-built stress-testing model helps leaders to better understand their business and the impact of economic shocks.
