How To Stress Test The Business.

I’ve successfully stress tested many businesses to withstand future financial uncertainty and change.??

Recently we’ve faced pandemic, war, climate change events, high inflation and political turmoil.?

And uncertainty on this scale is serious for business.?

The UK is set to exceed 20,000 liquidated companies in 2023 with all the associated consequences.

But it needn’t be this way.?

So what’s the issue???

Our cognitive biases steer our minds away from difficulty ahead. Most have short memories and make short term decisions based on emotion and not logic.

They build ventures for today, instead of for tougher times.???

But for the small prudent minority (and I mean small) there is huge upside in preparedness, options and strength.?

If you’re one of these rare people, I’ll now lay out 7 simple steps to build a robust stress test for your business today.

Let's get started.??

What is a Stress Test? ????

A stress test is an exercise to model what we think might happen in the future (sales, costs, cash collections etc).??

We then deliberately introduce pressure such as reduced sales, slower collections or increased costs to see what effect this has on cash, solvency and survival.???

We run this test over different durations to understand how the business will fare under different conditions and timeframes.?

This enables us to establish safe levels of cash reserves, assets which can be liquidated quickly and contingency plans should (when) the unexpected happen.?

The benefits of a stress test:?

• Based on real robust company data to give something meaningful.
• Once built it is easy to adjust and reuse regularly as required.
• It helps to create valid evidenced based cash targets.?
• It is designed to avoid future unnecessary risk.?
• It demonstrates good corporate governance.
• It is excellent for identifying priorities.???
• It provides peace of mind.?
• It sets you apart.?

So let’s run through how to do it….

Step #1: Build the Model?

Short term resilience is about having cash.?

So we need to build out an interactive cash flow for the immediate future, ideally stretching out 6-12 months ahead.???

We can then start to manipulate the inputs to apply stress and see what happens.?

I build cash flow models as spreadsheets. These are typically grouped by month showing cash collected in the month, costs incurred and ultimately a cash outcome for the month (positive/negative) and a net cash position taking into account the bank balance.?

These are all linked with formulas so that cash inputs can be adjusted and the net totals also then adjust accordingly.??

A cash flow model should be built based on the best available information and data for:?

• Expected business costs.?
• Expected cash collections.
• Expected future sales volumes.?
• Time lapse between incurring of costs and receipt of cash payments

In the first instance this should not be overly optimistic or pessimistic, but instead the absolute best approximation of what you feel will happen.????

Step #2: Stress the Sales?

Every business is different and the duration of a possible step down in sales is subjective.?

Which means we must design an appropriate and tailored test.?

Seasonal variations in demand may cause sales to drop somewhat for anything between a month and six months or more.????

As an example I have designed tests to model a 50% reduction in sales for 3, 6 months and more.?

This change has a knock on effect in terms of cash collected and hence net cash each month.?

You can choose multiple scenarios.?

For example:?

• A 50% reduction in sales for 6 months.
• No sales at all for 3 months.???

What does each test tell us? It will help to guide an understanding of how much baseline cash is required to comfortably survive.??

It also begs the question, how much of the monthly cost is fixed and how much is variable. How much can

be switched off temporarily??

Understanding cost flexibility is important. Levels of fixed cost may be addressable to reduce risk. But if a lot of it is “baked in” it means sufficient provision needs to be made if cash collections drop.?

Step #3: Stress the Collections

Sales may not change, but in difficult times, cash collections can be stretched out.?

The base forecast model should already reflect what happens now i.e. in normal operating conditions.?

For example, if you manufacture and sell physical products you may purchase (and pay for) materials in month one, sell the products in month two and receive payment in 30 days (i.e in month three). Broadly speaking.?This reflects a 60 day lag between incurring product costs and receiving finished product payments.?

In my own modelling (diagram above) sales in June for example would show costs for these sales incurred in May (month before sale) and receipt of payment for said sales in July (month after sale).?

Fixed overheads of course tick over regardless each month.?

Perhaps you run a service based business and don’t incur raw material costs. There will still invariably be a time lag between invoicing services and receiving payment.?

Under a stress scenario we start to stretch this timeframe.?

We may design a test whereby:?

• We extend payment receipts from 30 days to 60 days for clients.
• We increase the percentage of invoices that become delinquent or are written off.?
• If we have supplier payment terms, perhaps these are reduced or removed in terms of size of credit facility or number of days to pay.??????

Without changing sales volumes we can now introduce stress to our model just on the time lag effect of cash flowing in and out.???

Step #4: Stress the OPEX

Without moving sales volumes or manipulating cash collections the business can still come under stress if there is a movement in the operating expenditure.?

Perhaps through inflation or some sudden unforeseen circumstances (either unique to your industry or on a country wide scale).?

It’s therefore a good idea to think about:?

• Dialling up the OPEX to see the effect.
• Introducing lump sum costs - Repairs, new machinery, large one off hits.

Whilst OPEX excludes the cost of goods sold it is also worthwhile considering the implications of a shift in raw material and other direct product costs.?

If for example the business generally makes a 50% gross margin at the top of the income statement, it is worth exploring how to manipulate COGS (cost of goods sold) inputs to bring this down and see what happens.?????

Step #5: Combine the Elements

Sales, cash collections and operating expenditure do not occur independently of each other.

When something challenging happens it is likely there will be movement on multiple fronts.?

By combining the different factors it’s possible to build a very robust series of stress tests.?

For example:

?

• Base Case - All Inputs unchanged.
• Short Term Stress Case - 50% sales for three months and collection pushed out to 45 days.
• Long Terms Stress Case - 50% sales for six months, collections pushed out to 60 days and a 10% increase in OPEX.?
• Nuclear Scenario - No Sales for 6 months.?

Step #6: Find the Balance

Most companies do a poor job of building financial resilience, but the time to do it is when cash flow is positive and options exist.?

The trick is to find an acceptable balance.??

If you build a mountain of cash, shareholders will be asking for dividends and question the creativity and vision of the management team to invest and grow.?

This means there is definitely an upper (and of course a lower) desirable threshold.?

There are plenty of useful financial metrics to track short term liquidity (eg. quick and current ratios) and longer term solvency (debts to assets or debts to equity) which can be employed as part of a suite of financial objectives.?

However, it is wise to include the need to at any given time be able to pass a specifically designed set of stress tests, the likes of which I’ve just laid out.????

Step #7: Get the Fundamentals Right.

Passing a stress test requires financial resilience and this involves firstly making cash and then employing it wisely to build that strength.

Making cash comes down to profitability and this in turn means making the absolute most out of your business in your given market.??

Low profit businesses lose ground in their sectors and struggle to build cash (and thereafter resilience) versus the market leaders.?

Therefore it is vital your company is fully optimised for profit and resilience.?

Build an Avatar…..

A good approach is to design an Avatar model of an outstanding company in your sector.

You can then run a diagnostic to understand where the gaps and profit opportunities exist in your business against the Avatar.?

This direct approach allows you to move towards greater profitability, build cash and ultimately then pass a specifically designed robust stress test.??

A stress test will set you on the path to being one of the few that is armed and ready to withstand what we already know the market will throw at us.?

This will set you and your business apart.?

Here’s how to do it: How to Build a Business Avatar

If you'd like help building a bespoke stress test, then reach out any time. Contact me.

Whenever you're ready I can also help you in two other ways:

• A free business feedback call to listen and often advice on how I help you find and deliver profit and resilience opportunities: FREE BUSINESS FEEDBACK CALL
• Sign up for weekly webinars on building profit and resilience: WEEKLY WEBINAR SERIES