Why is scenario analysis important for P&L forecasting?

A P&L forecast is an attempt to predict the future of your business. This is captured within a financial model such as a spreadsheet. If you only create one version of it, then you are predicting only one version of the future as the drivers in your model are static. The market and the overall economy are not static. Many variables are continually changing. As soon as a variable deviates from your one model, then your output from such model becomes irrelevant. Scenario analysis is a way to predict what the future may look like under differing circumstances. The exercise itself also reveals your vulnerabilities and strengths.

Scenario analysis is a means to check the implications of the changes in the underlying assumptions/ drivers. Simply put, it helps organisation chart out execution plan should there be a change in underlying assumptions. It helps organisations formulate alternate business strategies in case of changes in the business dynamics. It also helps organisations prepare and re-orient execution of the alternate strategies should any of the scenarios gets triggered.

A technique to identify potential impact of different future scenarios, providing org with comprehensive understanding of potential outcomes in various circumstances. These insights help org with better decision making and strategic planning. It also helps to evaluate sensitivity of financial forecasts, this information allows to assess the org’s vulnerability to various factors and develop contingency plans to mitigate potential risks. By leveraging various scenarios and its potential consequences of different market conditions, economic fluctuations, geo-political and regulatory impacts, Fp&A team can be better prepared for potential risk and opportunities associated with each situation and translate insights for better decision making.

The first step is to understand and define the underlying drivers and establish the co-relation between cause (drivers) and the outcome (P&L line/ or even a Balance sheet line). I often quote an example of products nearing expiry in case of a Pharma or a beverage company. Typically, company will give additional discounts to ensure that the products are sold before the expiration date. While the sale will improve, but will have an impact on the margin In my experience in consulting multiple organisation, one of the mistake organisation make is that they look at only the P&L disregarding the consequential impact on balance sheet. Example, impact on working capital.

Identify - key variables impacting P&L Define - scenarios based on optimistic, pessimistic and baseline assumptions Adjust - key variables for each scenario based on the assumptions & conditions Calculate - financial impact and interdependence of each variable in different scenarios on P&L Analyse - compare variables across various scenarios, identify key drivers and sensitivities on P&L Assess - consider various external and internal factors that impact P&L, identify risk and opportunities in optimistic and pessimistic scenarios Develop - contingency plan to mitigate risk and capitalise on opportunities, very specific actions generated here Review - based on business dynamics, internal & external factors review and update scenarios

Scenario analysis in P&L forecasting is crucial for understanding risks and making informed decisions. Let's take Airbnb, for example, they might use sce. analysis in P&L forecasting to foresee how changes in tourism trends, regulatory environments, or economic conditions could affect earnings. By modeling scenarios like a surge in travel post pandemic or stricter rental regulations in key cities, Airbnb can strategise on marketing, pricing, and expansion, enhancing its adaptability and financial planning. This approach ensures preparedness for various market conditions, optimising financial outcomes.

It helps organisations formulate alternate business strategies in case of changes in the business dynamics. It also helps organisations prepare and re-orient execution of the alternate strategies should any of the scenarios gets triggered. In a nutshell, it enables business agility as organisations can quickly re-allocate resources in accordance to the revised scenario and the corresponding course of action.

Definitely scenario analysis is an important tool which provides valuable insights for stakeholders to make more mindful business Also with the amount of data available and AI tools can simplify this process and number of scenario can be created with minimum time with Gen AI Usually finance professional had a challenge of unstructured data, not having sufficient time to built on these models...but this process can be changed with usage of AI..

With Eg. for a a retail co.- The company's P&L statement is heavily influenced by sales volume, pricing, and costs. 1. Optimistic - Strong Market Growth Economy is booming, consumer confidence is high, market has strong growth. Co. expects an increase in sales volume & can potentially raise prices w/o negatively impacting demand. Co. anticipates cost efficiencies due to economies of scale & improv supplier relationships. With this scenario, co. can estimate the potential increase in revenue and profitability. This info helps co. assess the opportunities for expansion, investment, and resource allocation. It also enables to set ambitious but realistic targets and develop strategies to capitalize on the favorable market conditions.

Forecasting is about predicting the future. There are a lot of variables involved. Especially macro factors which you cant control. Scenarios allows permutations of these variables (upside, base case, downside) so you can be better prepared as the future unfolds.

In my experience, driving cross functional relevance and impact is the single most challenge. On paper, it can be de defined, but getting to an alignment cross-functionally is always a challenge. The second challenge is to determine the trigger point for the scenarios. Quite often or not, there is a state of denial that often results in being reactive. For example, drop in sales plan has a corresponding change in production plan, but orders would already have been placed to the vendors. Third, the parameters has to be extensive and platform driven. Making an excel model with 2-3 parameters only does not do justice to the concept and the effectiveness it can create

There are many variables within a P&L forecast. You can create many scenarios that are only subtle variations. The challenge lies in creating distinct, independent scenarios that are feasible for your business. This requires a deep understanding of the strengths and weaknesses of your business model vis-a-vis your market. Moreover, layering this with macro-economic conditions.

In my prior work experience, I have found it beneficial to model scenarios holistically, relative to a base case, so that all assumptions (revenue, costs of goods sold, personnel costs, other SG&A costs, working capital, capital expenditures, and liquidity) are evaluated. Take the example of a manufacturing company with international operations at the onset of the pandemic. Revenue pushout due to supply chain disruptions could lead to higher production costs, lower discretionary expenses such as marketing and travel, higher inventory, and greater use of lending facilities. A good scenario analysis will capture all of these moving pieces.

Two aspects that I will add: 1) The audience for which the analysis is done: I touched briefly, getting the cross functional alignment on alternate strategies is the single most important factor id defining not only the scenario but also the alternate business strategies 2) Selection of the right parameters: How often do we look at both internal and external parameters in conjunction? Example, macro economic parameters and the influence that it has as seen during pandemic or other events 3) Identifying the trigger points: I briefly touched upon this in previous sections. One should always define lead indicators that will indicate organisation and its leaders to switch to the alternate business strategy as the scenario has been triggered.