Modelling best & worst case scenarios to overcome inaccurate financial forecasts
The path you take your business will have many twists and turns.
You’ll encounter hills and valleys, forks in the road, and those narrow country lanes that take you into the back of nowhere.
Navigating this varied landscape can be treacherous.
Financial forecasts and strategic plans are the tools of choice for most businesses trying to identify the right route.
This maze of possible futures makes any single financial forecast irrelevant.
It doesn’t matter how much effort you pour into your forecast, it’s going to be wrong. Real-life always makes a mockery of your attempts at predicting it.
One single forecast doesn’t stand a chance at capturing the myriad possibilities that exist in your business’ future.
A more flexible and dynamic approach is needed. That’s where scenario modelling comes in.
Running multiple scenarios allows you to map the potential routes you could take your business down before you commit to them.
They can also help you establish the likely ups and downs you might encounter along the undulating path you do commit to. This is what we’ll focus on in this article.
We’ll be charting the way with 3 types of scenarios:
- Base-case: Your most realistic estimate of what will happen
- Best-case: Scenarios that are more optimistic but less probable
- Worst-case: Scenarios that are more pessimistic but less probable
There is an infinite landscape of scenarios you could traverse so how do you take on this activity without it consuming all your time?
We’ll stay anchored to reality by establishing realistic boundaries to these scenarios.
Knowing the limits of the landscape you are about to tread will prevent you from getting lost down the rabbit hole of possibilities.
What does a financial scenario look like?
So, what form does this map of the future take?
To take a quick break from the cartography metaphors, these scenarios are generally explored through the three key financial reports adopted by every business for their reporting.
It’s also a good idea to write up your assumptions, conclusions and the thoughts you have at the time. If you want this process to become a serious part of your planning cycle (and you do), you’ll be referring back to these reports and documents later on.
You won’t want to try and unpick them from memory!
Mapping out your base-case scenario
It all starts with a really solid financial forecast which forms the foundation of the rest of your scenarios.
This base forecast is itself a scenario, sometimes known as your ‘base-case scenario’.
A base-case scenario is the most realistic, most probable set of outcomes you can come up with.
If you were to put money on it (and you are!), then this is the one you bet on.
Once in place, it will allow you to create other scenarios, as you can modify the areas that have more uncertainty and variance.
Let’s run through some of the basics.
Forecast duration and format
A comprehensive format each scenario could take would be:
- 12-month to a 5-year forecast horizon
- Based on the 3 key financial statements: cash flow, profit & loss and balance sheet
- Each report is broken down into detailed categories
- A document outlining assumptions
Going as far out as a 5-year horizon is really a very strategic exercise to outline the goals and intentions of the company. It’s often used to demonstrate the potential of a business idea to investors in a business plan.
For most, 1-3 years is sufficient. This allows you to create your plan and budget for the next 12 months but then also see where this could propel you over the next 12-24 months after that.
The three statement approach
These financial statements are a universal financial language that can be read no matter what industry you operate in.
There is a reason the famous three are so widely adopted as they give you the most comprehensive picture of your businesses financial health available to you:
- Your profit & loss statement analyses your profitability and performance. It will help you judge if your business model and pricing strategy are working.
- Your cash flow statement helps you see if your business activities are generating enough cash to fund the business and ensure you can succeed without running out.
- Your balance sheet statement breaks down how much you own and owe, painting the full picture of financial health, risk and value contained within the business at any point in time.
The main drawback of these financial statements is that they can be fairly dense with accounting jargon and use generic top level reporting categories. They can be quite labour intensive to build too unless you have the right tool.
However, if these financial reports are built from a bottom-up process then it’s very easy to understand the results of each scenario you model.
The bottom-up forecasting process means scenarios are derived from revenue and expense categories in a great level of detail.
The figures you enter into these categories are based on the actual performance you think you can achieve with the resources available to you.
The more these categories mirror real-life business activities that are recognisably unique to your business, the better. When you start plugging in the figures, you’ll find it helps you keep them tethered to reality.
Low granularity, generic account labels are less useful for this process.
These low granularity forecasts really can fall foul of unrealistic expectations because the top-level figure is too far removed from reality.
It’s too easy to enter a figure without really thinking through how it’ll be achieved.
Building from a detailed level allows you to modify the performance of individual business activities in order to generate different scenarios.
Whilst the 3 statement method is widely adopted, it’s not the only format you can use for scenarios.
For example, you can build reports around the performance of your industry-specific KPIs or chosen north star metric
In the real-world business owners make decisions on gut instinct as much as they do multi-page strategic documents. Take advantage of whatever resources, data and expertise you have available to you.
The principles in this article will still be the same.
When it comes to entering figures, we’ve written a lot of articles on this topic. Here are some general tips:
- Analyse your historical data for trends
- Start with your known/reliable cost categories
- Create a detailed sales forecast
- Inform your forecast from other sources like conversion rates, website traffic etc
- Inform your forecast from your market research and competitor analysis
- Get your business partners or trusted employees to make their own estimates to help temper your perspective
In addition, here are some of the articles that will help you get started with your base forecast:
- A Beginner’s Guide to Forecasting Business Cash Flow for Startups
- How to start planning your sales forecast
- Cash Flow, Balance Sheet and Profit & Loss – The Key Financial Reports
You’ll spend most of your time on this forecast, carefully crafting it until you’re happy it contains sensible predictions.
Eventually, you’ll set these figures in stone so you can finalise your budgets for the period.
As time progresses, you’ll measure your actual results against this forecast so you can analyse whether everything is going to plan or not.
Before you get there, though, we’ve got to tackle the issue set out at the beginning of this article.
This forecast is wrong.
You don’t yet know where and you don’t yet know by how much, you just know that it is.
In order to be ready for these inaccuracies that will inevitably happen, we’ve got to start exploring further scenarios and factor them into our plans.
They say two wrongs don’t make a right. That’s not correct in the world of scenario modelling!
The right process here involves being hyper-aware of where a forecast is vulnerable to inaccuracies and compensating by building multiple scenarios for those areas.
Many of them will be wrong but you’ll be ready for the one that is right!
How to work through your best and worst-case scenarios
With your most realistic case for the future set, you can begin to look at other scenarios.
Best and worst-case scenarios are both less likely to happen than your base-case.
As we defined earlier, your base scenario should be the most probable version of events that will unfold over the coming months.
The scenario that you base most of your decisions around.
So, when it comes to your next scenarios, they will naturally start to dip into the realms of improbable events.
Whilst this doesn’t sound particularly useful initially, it’s crucial you engage in this exercise. This is how we escape the conundrum of trying to operate from a single, inaccurate forecast.
Whilst they are intended to be less probable, they should still sit within the boundaries of realism.
They could happen. Not just a once in a lifetime chance but a real possibility within the coming months.
In this way, they are realistic best and worst-case scenarios.
Don’t get me wrong, you do need to consider those more improbable events outside of your control like natural disasters, illness, burglary etc. This should inform your business continuity planning, insurance policies and emergency plans. Those insurance policies might be additional costs that have to be worked back into all scenarios!
However, you can’t form the basis of a strategic business plan around them since they are just too unpredictable.
A worst-case scenario you build here needs to contain realistic variations from your base-case.
The idea is that, in all likelihood, some combination of your best, base and worst-case scenario will happen.
Some areas of your business will perform well, some will dip and some will stay on target.
You don’t yet know exactly which combination it will be. Spending time now to carefully think it through should give you some hunches though.
The key point is, you’ve interrogated the financial consequences of all the realistic cases and you’re ready.
If you’ve done this task well, then when reality comes along, nothing will happen outside the remit of these scenarios (except for the truly unpredictable events). None of it catches you off guard.
An occasional unexpected event will hit, leading to additional costs or slowed progress.
Perhaps a positive unexpected event will happen like having your product endorsed by a celebrity.
Even if performance is poor, this performance still sits within the planned range since you’ve got behind the numbers and understood what drives the possibilities.
Because of this, poor performance is less stressful and less emotionally taxing.
You’re not so vulnerable to knee-jerk reactions since you’ve already thought them through in advance. You know it might happen, you’ve accepted the possibility.
It’s not practical to explore every scenario though, so we need to narrow down this infinite landscape ahead of us.
Plotting the landscape of probability
Understanding the scope of this landscape of probability is where the skill, expertise and experience come in.
You won’t always get this range right, and despite best efforts some events are still going to catch you off-guard. You’ll get better at judging this over time though.
So how do you establish this range?
How high could the peaks be and how deep could the valleys go? Do you just add 10% more sales for your best case and subtract 10% for your worst case?
This is a valid approach that will generate some quick ‘what-if’ scenarios to think through.
Simply understanding whether your business can cope with varying degrees of sales performance is a useful exercise in itself. How long before the money runs out if sales dry up?
Whilst quick, this is still a very simplistic approach. Speed isn’t the only goal here, you’re trying to gain insights into your business and set grounded expectations for what is to come.
To be a skilled cartographer of the future you need to recognise the knock-on impacts that different levels of sales could have on your business.
A best-case scenario with an overwhelming amount of sales might lead to a backlog of orders you can’t fulfil.
You might need to order in more inventory in advance which perhaps you don’t have the ready cash for.
You might need more staff hours to process the requests.
There might be more customer support that takes team members off other mission-critical work.
These factors all have monetary and timing consequences to your evolving forecast.
This means a level of hand-crafting needs to be applied to each scenario, beyond just massaging one figure, in order for it to adequately reflect reality.
This is why I emphasised earlier the need to build your forecasts from bottom-up categories. It’s this detail that you can delve into here to create meaningful scenarios.
Modelling an overwhelming amount of sales could lead you to take certain actions now across your business to make you more prepared for that eventuality.
However, is it realistic?
Unless you’ve got a plan for generating that incredible sales volume, it won’t happen all by itself. Not without some unexpected boon like the aforementioned celebrity endorsement.
So, for the purpose of this exercise, you shouldn’t linger too long on these wilder scenarios.
You can’t make any sound business plans around hoping for an out of the blue celebrity endorsement or a promotional video going viral. If you are making business decisions assuming something like this will happen, in all likelihood you’ll be in for a rude surprise.
So, how do you establish your boundaries? When does an optimistic sales scenario go from realistic estimations to wishful thinking?
What’s the highest peak on this landscape that you can hike to?
The highest peak and the deepest valley
In the article How to Create an Effective Financial Forecast With No Historical Data I set out the steps you take to mitigate a lack of historical data when trying to build a forecast.
- Identify the key metrics that drive your sales
- Research industry benchmarks
- Work out your confidence levels
- Plan realistic scenarios
One of the primary lessons that the article explores is a method for setting realistic expectations.
Knowing the upper limit of industry benchmarks relevant to your business allows you to gauge where you are against standard industry performance. Unless you are truly breaking new ground, you are unlikely to beat the industry best.
A relevant industry benchmark here might be the conversion rate of an e-commerce fashion website.
If you have people on your team building your website who have a track record of success in the industry, you might consider your confidence levels high for hitting that benchmark.
If you’re bumbling through building a website for the first time yourself, you might have low confidence levels in your conversion rates.
This form of data, coupled with any historical data you do actually have helps you reign in your peaks and valleys to realistic heights.
You’ll find that you can be very targeted about this approach too.
Large areas of your base-case scenario will be the same across all scenarios.
You might know exactly what your rent bill is for the year. If you have a good relationship with your landlord you might also know well in advance when the bill is going to increase.
There is no need to explore worst-case scenarios where your rent unexpectedly doubles since this is unrealistic. Your confidence is high that the figure will stay the same.
Spend some time identifying the areas of your business that are likely to have the most variance. These are the areas that justify the most modifications in your scenarios.
Completing the map and choosing your path
Whilst you explore the upper and lower ranges of your performance, you’ll likely uncover new insights that make you rethink your base-case.
A full exploration will naturally introduce some back and forth between scenarios, crafting, tweaking and reflecting upon what it’s all indicating.
At some point, you’ve got to put the pen down, let the ink dry and commit to your figures.
This commitment will help you create your strategy for the coming months, set your budgets and your goals.
You’ve chosen your path but you’re also now keenly aware of where it could deviate. All that’s left is to track your results and see where in this landscape reality falls.
What happens when a global pandemic halts the world economy for months on end?
It’s difficult to write an article that refers to worst-case scenarios without recognising the current global situation we’re all enduring.
If I’d written this article last year, perhaps I would have used the title for this section as a hypothetical event outside your control that you simply can’t plan for.
An exaggerated example to make the point more dramatic.
What a portentous article that would have been.
So what do you do when a volcano erupts, reshaping the very landscape you’ve been carefully plotting your path through?
Once the ground stops shaking and the dust settles, all your carefully crafted plans are left invalidated.
Does it make the entire forecasting and scenario modelling process invalid too?
The current pandemic is an extreme and rare event but every year some form of unexpected event will impact your business that you could never have planned for.
When this happens, you have no choice but to start re-plotting the new landscape you find yourself in.
Plans generally age badly and they always need updating in the most stable of times.
Not having a plan isn’t a viable alternative though.
Ultimately, the forecasting and modelling process brings more to the table then just a static plan that you stick to dogmatically.
Keeping a close eye on the factors that drive your success gives you a deeper understanding of your business. You’ll learn so much along the way about what works and what doesn’t.
When you are faced with your revenue figures for the month, you’ll be far more ready to investigate and explain why they are better or worse than expected.
Planning, forecasting and modelling scenarios gives you a chance for introspection and reflection. This is invaluable for choosing the right path ahead, even if you do have to change course in the future.
It’s a discipline that encourages you to ask important questions about the future and understand the consequences.
Right or wrong, you’ll still benefit from the process.
Picking your scenario modelling tool
Creating financial reports can be time-consuming. You need to be able to rapidly change, test and adapt your scenarios to swiftly map out the landscape of possibilities.
Building all those reports and variations could get quite arduous!
Our software (Brixx) builds bottom-up scenarios that automatically generate detailed cash flow, profit & loss and balance sheet statements, cutting down this time-consuming process.
In fact, it’s pretty much designed for the process outlined in this article (what an interesting coincidence)!
If you’d like to follow the advice in this article, grab yourself a free 14-day trial.