Record Point is an independent corporate advisory firm with operations in Sydney and San Francisco. We specialise in domestic and cross-border advisory services for public and private companies including mergers and acquisitions, capital raisings, corporate partnerships, debt advisory, restructuring, strategic reviews and valuations.
The COVID-19 pandemic has created the most uncertain and unpredictable economic environment in memory for businesses in Australia and around the world. As a business owner or manager, irrespective of the size of your organisation, proactively dealing with operational issues, heightened tracking, scrutinising of the financial position and performance of the business has become an imperative part of planning, pivoting and ultimately for many, surviving the inevitable challenges that lie ahead.
Financial modelling provides decision makers with essential data points for a business “health check” and the critical information to support important business decisions. From our discussions with clients during the COVID-19 lock-down, it became apparent that there is a wide gap in how businesses approach their financial modelling, and we also found that many businesses are actively upgrading and enhancing their capabilities.
In this blog, we have highlighted some common areas where the current environment is requiring deeper thinking about modelling and forecasting.
Engaging with a broader group of stakeholders
Many businesses have traditionally done their financial modelling for a reasonably narrow group of stakeholders such as the owner or CEO. The modelling process is often undertaken by an accountant or financial analyst and the output of the model remains unchanged for years.
The current environment calls for a broadening of all of these items. Financial models need to consider that there is a broader range of users of the critical forecast information including owners, directors, managers, financiers and potential investors. Owners and managers may be focused on cash flows, revenues, costs and working capital whereas financiers may be focused on capital structure, solvency, liquidity and covenants. The process for compiling the forecasts should be reconsidered including involving more line managers and other relevant contributors to enhance confidence in the assumptions and develop the appropriate sensitivity analyses. Given the uncertainty of the economic recovery, we expect that forecast reporting is likely to look different going forward than it did in the past for many businesses.
Greater granularity
Some businesses with less sophisticated modelling functions or small accounting/reporting teams generate their forecasts by utilising outputs from their accounting software and exporting them into Excel with high-level go-forward assumptions (such as revenue growth rates and earning margins). These and similar approaches are relatively simple and may have been adequate in the relatively steady-state pre COVID-19 environment.
Many businesses are now finding that the current environment necessitates greater granularity in their financial modelling which may require significant modelling changes. Key to this process is better analysing each of the components of revenue and modelling their key drivers separately, and similarly, where practical, compiling bottom-up reconstructions of material cost items. In addition, some businesses are reconsidering the frequency of their models with monthly models being expanded into weekly, and in some cases, daily forecasts.
We are not suggesting that any of this is a simple task. Businesses might decide to implement these changes incrementally over a workable period.
Scenario analysis
Scenario analysis provides the forecasting process with a range of future outcomes based on potential events or assumptions. Questions that business owners are asking include how deep and how long is this downturn going to be, what is the likely shape of the recovery for the broader economy and how will that impact their business, will they have enough cash to navigate through a potential second or third wave of COVID-19, and how much funding will they require to build up their working capital position during the recovery?
Not all financial models were created with the flexibility to run multiple scenarios, however with many significant and uncertain variables, it has never been as important to have an ability to efficiently stress test the base case forecast assumptions in order to make informed business decisions.
Integrated financial statements
There are numerous businesses with evolving forecasting capabilities that have historically focused on revenue and earnings as the key proxies for the financial health of the business. However, the current environment demands a more integrated and robust approach with a sufficiently detailed profit and loss statement, balance sheet and cash flow analysis providing the basis for a more fulsome perspective on the financial performance and condition of the business. With the current focus of analysis being on closely tracking the cash flow and liquidity of the business, there is a lot that might get lost if the full balance sheet is not adequately modelled, including the financial implications arising from changes in working capital and capital expenditures.
Capital structure
The capital structure of a business refers to the sources of capital, whether equity or debt, and the financial modelling of these items are often highly simplistic. It is likely that a large number of businesses will be seeking to raise additional capital which provides for an opportune time to enhance financial models to more accurately demonstrate the impact of various forms of new capital on the business. While external financiers and investors will likely establish their own financing or “leveraged buyout” models to track the sources and uses of new capital, businesses need to be able to run their own analysis and sensitivity tests to retain control of their risk profile, ability to obtain funding and impacts on shareholder returns.
Conclusion
With the unexpected economic shock that materialised as a result of COVID-19, many businesses found themselves with inadequate financial modelling capabilities and with insufficient information readily available to quickly make important business decisions. When modelling in a COVID-19 environment, businesses should consider investing in their capability and will benefit from expanding the group of stakeholders involved in the forecasting processes, additional granularity and detail, incorporation of multiple scenarios, expanded and integrated reporting across the profit and loss statement, balance sheet and cash flow as well as the ability to model potential capital structure changes.
Record Point has significant experience across a wide range of industries to assist with your next capital raising, acquisition or divestment. If you are currently considering your M&A or financing options, please feel free to reach out to one of the Record Point team for a confidential discussion.
May 28th, 2020