COVID-19: Scenario analysis in uncertain times
The impact of COVID-19 has made it exceptionally difficult for businesses to plan ahead. One key way of mitigating this challenge is by undertaking a scenario analysis, to try and uncover a clearer picture of the way forward. We’ve answered the top questions that business leaders might have about starting that process…
How much money do we need? And for how long?
With the level of uncertainty that currently exists for companies, many business owners are rightly shifting their focus from the income statement and balance sheet, to that of embedding a focus on cash flows within their businesses. A key finance tool to help support robust cash management, and future budgeting, is an integrated three-way cash flow forecast which considers a range of possible scenarios and resulting business outcomes.
Furthermore, a cash flow forecast with scenario analysis is often required by lenders, financiers and equity providers for further capital requests, government support packages such as the Business Debt Hibernation Scheme (BDHS) and the Business Finance Guarantee Scheme (BFGS), and Companies Act business rescue tools.
But during times of business uncertainty, such as the COVID-19 pandemic, it can be challenging for some businesses to get their heads around what different scenarios might eventuate, particularly when there are many economic elements out of your control, i.e.:
- How long might we be in different COVID-19 Alert Levels?
- Once the virus is eliminated, or substantially under control, how long will it take for people’s pre COVID-19 habits and behaviour return to normal – if at all?
- If your business is global, when might global markets open up?
- How has this widespread health pandemic affected suppliers and the ability to distribute goods or service clients?
- How have customers been affected and what impact is this going to have on cash inflows?
I don’t even know where to start?
Undertaking a scenario analysis in uncertain times can be overwhelming, especially when economic assumptions are a moving target and the impact on - and re-emergence of - wider business activity is unknown.
But despite the difficulties and uncertainty in performing a scenario analysis, it is a key part of cash flow forecasting. It provides insight into the impact on a business of potential outcomes, the results of which are vital to consider when identifying key decision points and developing business responses. If elements of the scenarios planned eventuate, businesses can respond quicker given the prior investment in critical thinking about outcomes.
Scenario analysis is also a useful tool to highlight any potential funding gaps or periods of surplus cash, and to ascertain what business levers might be available under different scenarios to remain cash flow positive.
What are some of the basic types of scenarios management should consider when preparing a cash flow forecast?
A basic scenario analysis will aim to include three to four scenarios, with assumptions on activity levels under each scenario and how these impact on your revenue/income and fixed and variable costs, amongst others.
The scenario types that we present in this article serve as a useful starting point for your analysis but will require modifying for your business, and the specific industry in which you operate, to be relevant.
The most common scenario types in cash flow forecasting include:
- Base case or status quo: the starting point of a scenario analysis. Under normal business conditions, this scenario would reflect “business as usual” assumptions. However, under COVID-19 circumstances, you may want to use this scenario as a “wait and see” to reflect your business in temporary hibernation until some form of business activity resumes.
- Worst case: reflecting a sustained economic disruption due to COVID-19. This case assumes the pandemic is not contained and a prolonged recession results in a significantly delayed economic recovery.
- Mid case: your best estimate of what the future might hold. In COVID-19 business circumstances, this case might reflect assumptions of a slow economic recovery where the pandemic is largely contained but the economic cost has been significant.
- Best case: assumes a rapid economic recovery from the impact of COVID-19. This case sees New Zealand move relatively quickly out of COVID-19 Alert Levels and into some form of normalcy as the pandemic is well contained.
What activity levels do I assume under each scenario?
Business activity levels under each case are driven by your assumptions regarding the level of economic activity and recession or recovery. In April 2020, the Treasury released their report on economic scenarios resulting from COVID-19, which made assumptions on activity levels under each COVID-19 Alert Level. This is useful information to consider in your scenario analysis and could help shape your assumptions of wider business activity under each scenario.
As an example, the Treasury assumes a 25% and 40% reduction from normal output at Alert Levels 3 and 4 respectively. A worst case scenario could assume an extended time in Alert Level 3 as New Zealand struggles to contain the pandemic.
On the other hand, a best case scenario could assume a movement to COVID-19 Alert Level 2 as soon as early May 2020, with a corresponding 10-15% reduction in output, from normal, as assumed by the Treasury.
Deloitte Access Economics has also undertaken further analysis on potential post-COVID-19 scenarios, and the economic impacts thereof. A copy of the April 2020 report can be obtained by contacting our Restructuring Services.
What would your business do under each scenario?
Once you have considered what economic activity could look like under each of your scenarios, the next step is to examine the business levers available under each scenario and flex your business response accordingly.
Business levers and assumptions could include:
- Cash outflows: curtailing discretionary spending, hiring freezes, organisational restructures, negotiating payment holidays, amending trading terms, cost relief options and contract renegotiation.
- Cash inflows: muted or stagnant growth assumptions, receipt of stimulus packages, non-essential asset sales, additional capital from either debt or equity sources, collection of debtors, and diversification of markets and business operations to include contactless service.
In closing, it is important to consider and plan for ways to preserve cash now. Scenario planning is the right tool for the job and will assist with quantifying any cash deficit, how it is going to be funded and what your future business could look like.
Deloitte is experienced in the areas of business rescue, turnaround and scenario planning. For further guidance, please contact one of our Restructuring Services.
The content of this article is accurate as at 7 May 2020, the time of publication. This article does not constitute professional advice. If you wish to understand the potential implications of current events for your business or organisation, please get in touch. Alternatively, our COVID-19 webpages provide information about our services and provide contacts for relevant experts who can help you navigate this quickly evolving situation.
With over 20 years in the restructuring industry, I am passionate about working with clients and their stakeholders to help them make effective decisions. These are decisions that will ultimately optimise the value of their business and address challenges associated with financial distress.