10 Modeling Financials with Scenarios

Financial analysts often rule the organizations in which they live (Smith et al., 2011). Their analyses tend to capture the attention of leadership in two important categories: (1) quarterly earnings and (2) return to shareholders (Gelles & Yaffe-Bellany, 2019). In most cases the board’s expectations are a direct result of the model built by the finance team. The reality is that most companies and CEOs are held to their boards’ expectations. The demand for a quarterly financial growth outcome is hardly supportive of organizational longevity (Collingwood, 2001; Millon, 2002; Zhang & Gimeno, 2016). Squeezing as much profit as possible out of any organization—regardless of the impact on people, expertise, workforce capacity, communities, states, and nations—has become the norm (Guerrera, 2009). Indeed, the focus on short-term gains has almost replaced the idea of a long-lived organization.

Onceagain, it is probably unfair to start this chapter so harshly, though the reality is difficult to deny. The purpose is not to unfairly rake the finance officers over the coals, yet it is hard to ignore the influence and the tremendous impact on strategy given that over 90 percent of Fortune 100 companies put strategy in their finance departments (Benninga, 2014; Gelsomino et al., 2019; Kono & Barnes, 2010). To be fair, no activity within an organization should be supported if there is not an expectation of something gained (Swanson, 2001; Swanson et al., 1999.). Investments in activities like scenario planning, leadership development, and training should be expected to produce something of value. Without that, there is no reason to proceed.

Scenario planners have long avoided the need to demonstrate the financial results of their projects. Imagining futures can be a fun and creative activity—and it can lead to insights. But unless those insights can connect to doing something differently that can have a measurable impact, there is a risk that scenarios will be dismissed as something interesting but without real value.

There is no advice for connecting scenario planning activity to forecasted organizational performance. Many will say it is too difficult and that there are too many other variables that could influence financial performance. Yes, these arguments are partially true. It is not easy to estimate the potential impact of scenario planning on organizational financial performance, and many variables play a part in organizational performance into the future. However, just because something is difficult does not mean we shouldn’t pay attention to it. With some adjustment, it is possible to estimate the ways in which scenarios could affect an organizational financial model, and it is possible to estimate the effects of scenarios on firm performance.

Scenario planning has to be linked to financial outcomes in order for it to be accepted as a common organizational practice. Because scenarios deal with the future (just like financial models), it is not necessary to have finite and actual financial outcomes. We cannot predict the future. But it is possible to estimate the impacts of scenarios and the events they contain on the current financial modeling. This requires bringing the finance people into scenarios and attempting to spark their creativity. While this may seem a difficult task (finance people are not often known for their creativity), there is one important thing that scenarios and financial models have in common: assumptions.

The purpose of this chapter is to describe specific ways that scenarios can be connected to financial models. This chapter will cover the following:

• What a financial model is

• How financial models are used

• How to connect scenarios and financial models

What Is a Financial Model?

A financial model is an estimate of a business’s forecast of earnings into the future (Benninga, 2014). Usually, it is based on a set of assumptions for how the business will perform. Aligned with strategic planning (and the assumption that the world will not change), most companies work on a single financial model. Most financial models are built on the organization’s historical performance and then projections are made into the future.

Diferent Types of Financial Models

There are five types of financial models: (1) the three-statement model, (2) discounted cash flow analysis model, (3) leveraged-buyout model, (4) merger and acquisition model, and (5) sensitivity analysis (Pignataro, 2013). By far, the most common of these is the three-statement model. The others are used for more specific purposes. The three-statement financial model consists of the income statement, balance sheet, and cash flow statement. Of these, the balance sheet is the most important. Figure 10.1 provides a generic balance sheet.

How Financial Models Are Used

Financial models are generally used to estimate expected organizational performance into the future. They are used to make decisions about how to raise capital and grow the business and are also used in planning, accounting, allocating capital, and potential merger and acquisition activity. Financial models are used to understand the value of the business and include the major levers for making decisions (e.g., income, assets, debt).

Using Financial Models with Scenarios

Bringing scenarios and financial models together creates an opportunity to explore multiple financial models—one for each scenario. The goal of using financial models with scenarios is to consider forecasts of the most important aspects of organizational performance into the future and attach them to each scenario—in other words, to consider how the financial model might change according to the dynamics of each scenario. There is no right answer to the activities described in this chapter; they are speculative.

It is tempting to think that financial models are based on objective data. In fact, financial models require just as many assumptions as scenarios. Financial models are, by definition, estimates. Many of the principles in chapter 9 apply to using financial models within and across a set of scenarios. Instead of estimating the potential benefits or losses around specific actions or decisions, using financial models is intended to look at the organization as a whole.

Because scenarios and financial models make assumptions, there is a logical starting point for connecting the two. Common assumptions in financial models include industry growth, inflation, interest rates, currency rates, capital expenditures, market share, and taxes. Overlooking the fact that financial models make assumptions is one of the reasons they are so seductive and sometimes blindly adopted. The reality is that financial models are every bit as speculative as scenarios. Often, scenarios contain the same or very similar assumptions. Finding the overlap between the scenario assumptions and the financial model assumptions creates the ability to estimate the potential financial impact to the organization.

Most organizations use Workday Financials or Oracle Financials, and most finance teams download their financials to Microsoft Excel, play with them, and when satisfied, upload them back. The resulting model often becomes the decision-making frame used by the CEO and the board, as suggested above. The main problem with this approach is that managing entirely by the numbers usually doesn’t turn out well (Foroohar, 2019). Even the classic management guru W. Edwards Deming (1991) included managing by the numbers as a cardinal sin. Looking at the numbers in a few different ways recognizes their instability and reveals options.

Putting scenarios together with financial models means breaking the dedication to a specific set of financial assumptions that often go unchecked. It means identifying those assumptions and making them clear. Once that is done, there is room to explore a few different versions of organizational performance based on what the scenarios have to offer.

Using Financial Models with Scenarios

There are two main ways to think about bringing scenarios and financial models together. The first is to estimate how the major indicators of organizational performance are potentially impacted by the dynamics of each scenario. The second is to consider the overall effects of scenario planning on the preferred financial model after they have been used for decision making. These two ways to connect scenarios and financial models are practical ways of assessing scenario impacts on organizational performance.

The balance sheet provided in figure 10.1 is overkill for the purpose of connecting scenarios and financial models. Figure 10.2 presents a simplified financial model adjusted for use with scenarios. This model includes the most important indicators of organizational performance that are likely to be affected by the dynamics that scenarios generally contain. Of course, financial models may have different parts depending on organizational accounting and finance preferences, but the main elements are there. This version will do the job, or you can create your own. The essential elements should be revenues, major costs, operating expenses, operating income, and, of course, net profit.

Example: Healthcare Organization

In a recent scenario project for Healthcare Organization, there was an opportunity to explore how the assumptions of scenarios could affect the financial model. While many of the activities described in this book were used, the final task was to interpret how the financial model could be impacted by the conditions of the scenarios. Once the finance team was able to review the scenarios, there were clear implications for expected revenues and costs of sales (figure 10.3).

Because of confidentiality, it is not appropriate to provide in full detail how the figures were estimated and the organizational context. But the idea should be easy to understand. For example, under scenario 1, the finance team saw that the conditions of the scenario would have a negative impact on organizational revenue sources. In addition, there was a perception that costs of sales would increase. You can see the impact to the net profit. Scenario 2 involved more favorable conditions, which led to an assumption of increased revenues. Cost of sales also increased owing to the expenses associated with expected organizational growth in that scenario. This activity provided a snapshot of how each scenario would impact organizational finances. Scenario 4 involved opportunities for growth that supported significant revenue increases. Of course, none of these options offered enough evidence to say with certainty which would come to be.

The important takeaway is that scenarios allow for exploring the expectations of revenues and costs that change according to different environmental conditions. Thinking through the implications for organizational performance overall is critical to getting away from a single financial model and the revenue projections that usually accompany it. In short, scenarios should be used to question the assumptions of the financial model, just as they are used to question assumptions for major decisions or investments.

Workshop Format and Guidelines: Modeling Scenario Financials

Time: 2 hours.

Participants: 5.

Assumptions: You have a set of scenarios and an existing financial model.

Workshop Format: This activity can be done in a workshop format, or by providing the scenarios to the finance team along with the instructions below.

Instructions:

• Assemble the finance team.

• Ask participants to read scenario 1 and consider the implications for organizational performance.

• Adjust the major categories on the scenario financial model and fill in the columns for each scenario.

• Repeat this process for the remaining scenarios.

Overall Financial Model across a Set of Scenarios

Another opportunity to think about connecting scenarios and financial models happens after the scenarios have been used and decisions have been made. The goal is to estimate how the scenario exercise overall may have impacted the critical elements of the financial model. Staying with the Healthcare Organization example, figure 10.4 provides an estimate of the overall scenario exercise on expected organizational finances. In this case, decisions were made as a result of the scenarios that led to increased revenue from new customers, higher prices, and other new revenue sources. To be more specific, the scenario work was with the IT department of Healthcare Organization, and the scenarios contained situations that would require a work-from-home option. While the scenarios did not contain a pandemic, they did contain other events that forced offices to close and people to work remotely (with the support of IT). Healthcare Organization was able to support a work-from-home option within 48 hours of the state’s critical stay-at-home order due to the COVID-19 pandemic. Sometimes, scenarios do not get the exact events right, but the implications are almost identical.

Workshop Format and Guidelines: Overall Scenario Financial Models

Time: 2 hours.

Participants: 5.

Assumptions: You have a set of scenarios, four to six months have passed since you developed your scenarios, decisions and/or allocations have been made, and you have an existing financial model.

Workshop Format: This activity can be done in a workshop format, or by providing the scenarios to the finance team along with the instructions below.

Instructions:

• Assemble the finance team.

• Ask participants to read scenario 1 and consider the implications for organizational performance, given recent decision making and/or resource allocation.

• Adjust the major categories on the scenario financial model and fill in the columns for each scenario.

• Repeat this process for the remaining scenarios.

Summary

CEOs, finance officers, and managers of complex organizations have options when thinking about how scenarios can be useful. It is well documented that scenarios can help people think differently (Brooks & Curnin, 2021; Chermack, 2004) and expand their views of how the environment could change in surprising ways (Rickards et al., 2014). To get the most out of scenario planning requires commitment and discipline in using scenarios to understand the many ways that environmental changes can challenge the organization and its financial security. To do this effectively means paying attention to the outcomes of scenario planning at multiple levels of the organization, including its overall financial health. This can be difficult work that requires financial estimation and assumptions.

This chapter has described how scenarios can be used to challenge the overall organizational financial model and examine it in a few different ways. Scenarios are not just conceptual thinking tools; they contain assumptions, like every financial model. Connecting the two can lead to important insights and support decision making across the organization. For scenario planners, it is important to understand the potential benefits of what you do and to communicate that to a client organization. Bringing scenarios together with organizational financial models is a critically important way to make it clear that scenarios can instruct finance officers and prepare the organization—financially—for significant shifts in the external environment.