The global financial crisis has dramatically increased the speed at which business conditions can change, forcing many business owners to rely more than ever on risk management strategies to protect their businesses. Stress testing a business can be an effective way to ensure a business survives unpredicted change.
Many companies are getting stuck in the current economic climate because they are not prepared for change. They start working on the problem after it has already arisen. By the time their plan of attack is implemented, the impact has already caused serious damage to earnings, cash flow and the overall viability of the business.
Businesses need to understand first how they would be impacted by an economic downturn on a ‘worst case scenario’ basis, and then take appropriate defensive action.
Regardless of the position a business is in, it’s essential to undertake detailed financial modelling and “what if” scenario testing to gauge how various sudden changes in market conditions will affect the business and more importantly, what initiatives management can deploy to combat these challenges.
Organisations should be focusing their attention on stress testing their business to minimise risk.
There are many benefits to be had from stress-testing. These can include:
- Enabling a business to react quickly if conditions change suddenly
- Forcing a business to ask ‘what if’ and creating strategies to deal with given scenarios to minimise risk and maximize opportunity
- Providing clarification around short to medium term capital requirements
- Placing management in a stronger position if they need to negotiate with financiers by showing they are prepared for and able to handle challenges
- Increasing the confidence of key stakeholders
- Minimising stress on the business when the tough decisions have to be made
- It will provide management with an advantage over their competitors
Rigorous stress testing has enabled organisations such as Brambles and Qantas to move quickly when market conditions suddenly changed. When yields slumped more than expected in March 2009, Qantas quickly slashed forecasts and initiated a range of dramatic measures to reduce operational costs. It is this ability to rapidly respond to change that enabled their survival.
In order to conduct an effective and thorough stress test program, there are a number of key questions a business owner must address. These include:
- What is the new breakeven level for the business and how does it change from the previous level?
- What is the impact on revenue and earnings if you lost a major customer?
- If customers are demanding lower prices, what is your tipping point and are you prepared to lose customers in order to maintain earnings? What changes will you need to make to your cost base to match the new lower revenue base?
- How is cash flow impacted if debtors take an extra 10 days on average to settle their accounts?
- Could there be a breach of banking covenants and if so, how will you respond to your financiers concerns?
- What changes will you require to your banking facilities and what would be your banks attitude to an increase in lending, if required?
- Are staff cuts needed and how will you deal with this (4 day work week, pay reductions, retrenchments)? Do you have the cash flow to fund redundancies?
- What overheads will you reduce and what capex plans need to go on hold to preserve cash?
- What non-core assets could be sold to reduce debt/provide additional cash flow?
- Are sales or production levels too low to remain viable and is a merger/strategic partnership needed to maintain critical mass? Who would you approach?
- What plans do you have to meet ATO requests?
Stress testing enables management to act nimbly when unexpected changes happen. This means that management can make prudent, sometimes lifesaving decisions very quickly. Businesses that are able to adapt to change are the ones that will prosper in the future.
Michael Fingland is the Vantage Performance managing director (www.vantageperformance.com.au)
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