In every recession we hear calls from the Fed for banks to run stress tests (Here’s a recent example press release from them on the topic). These tests help managers understand the various scenarios that could become reality in the future and what their organization might look like if they do.
Every private company manager, owner, and board should be doing this now.
Top consulting firms are increasingly, and wisely, giving guidance that non-bank companies should run stress tests as well. As unprecedented fluctuations in our economy unfold and we hopefully edge closer to a post-Covid world, every private company manager, owner, and board should be doing this now. While the term “stress test” has become synonymous with big banks and might sound overwhelmingly complicated, it doesn’t need to be. Running a stress test on your business can be surprisingly easy.
…The next step is the sensitivity analysis. This step is the crux that sets what you are doing apart from almost all other financial analysis you’ve done on your business.
Most business owners should be able to run through the below steps without much trouble. If you usually leave the details to your accounting or finance folks, then pass this on to them or give us a call for assistance. The important thing is that this gets done.
If you already have a 3-statement (income statement, balance sheet, and cash flow statement) pro forma, which you should, then running the stress test will be as simple as adding some functionality to that. We use Microsoft Excel’s “Data Table” function to run the mechanics and a bit of understanding about the business to determine which variables to plug in. Just as owners of businesses with any type of asset or liability (which is most of them) need to understand all three of these statements to understand true value creation (more on this here), a comprehensive stress test needs to run through all three statements as well.
While the term “stress test” has become synonymous with big banks and might sound overwhelmingly complicated, it does not need to be. Running a stress test on your business can be surprisingly easy.
Even if you don’t have a 3-statement pro forma you can receive much of the value of the exercise straightaway:
1) Export your income statement into your favorite spreadsheet software. The appropriate time period for the income statement will vary depending on your business, but for most the previous month will be best.
2) Identify which line items are variable and which are fixed. Then mark each with a “V’ or “F.” Variable expenses could be in Cost of Goods Sold or in Operating Expenses so be sure to check both sections.
3) For each “V” line, create an assumption for how it varies with revenue. So, if credit card processing is always 3% of revenue then be sure to add an assumption for that so you can properly estimate what it will be for various revenue levels. When you’re done, you’ll likely have several variable line items and corresponding assumptions and have something more elaborate than the simple example below.
4) Build scenarios for each state of the world you think could become a reality. Make a separate column for each scenario and within that column list all assumptions you are making. Name each scenario so you and any readers of what you are building will know what is being shown. So, one name might be “Bank Relief, No Landlord Relief, and Closing the TX and FL Stores.” (This isn’t the place to make scenarios named “Revenue decrease of 10%” and “Revenue decrease of 20%.” That would be sensitivity analysis which is in a following step.) Some things you’ll want to think of might include:
What if I am able to negotiate a suspension in rent payments for the next three months?
What if my bank allows me to halt principal payments for some time?
What if my bank also allows me to suspend interest payments for some time?
What if I close some number of my locations until the current crisis is over and therefore save some fixed expenses?
(For those building a balance sheet stress test as well) What if my customers start paying me slower than they usually do?
(For those building balance sheet stress tests as well) What if I am able to negotiate with my vendors to make slower payments during this time?
A simple example of what your scenarios might look like is below. You’ll likely have more assumptions and better names.
5) If you already have a 3-statement pro forma, now link all scenario assumptions to the appropriate future time periods. If you don’t have your pro forma yet, then just build a new column right next to the income statement and let that represent the next time period (see the chart just under Step 3 above for an example). Be sure to connect each line item with a “V” to the revenue in this new column and be sure that each line item that would be impacted by a scenario has the appropriate value.
6) Decide whether to automate or not. If your proficiency with spreadsheets is high, you can start linking your scenario values to your income statement so that the results become automated. If you don’t have as much experience, don’t be discouraged, simply build an extra income statement column for each scenario that you’ve built.
7) Next is the sensitivity analysis. This step is the crux of the process that sets what you are doing apart from almost all other financial analysis you’ve done on your business. Identify the key variables that will likely vary in the future and the degree that variation would affect your decisions as a manager. For almost every business this will include revenue. It could also include duration of revenue slow down or amount of labor force to furlough.
8) Pick a dependent variable that is critical to the success of your business. If you are building an income-statement-only stress test, your dependent variable will likely be net income or free cash flow. If you are building a full stress test you’ll be able to get to even more critical variables such as minimum cash balance, required line of credit draw, or borrowing base capacity.
9) Now pick each scenario and run it through your sensitivity analysis. You are effectively stressing each scenario to see how much your business can take before there are problems. So plug in the first scenario and then lower the revenue by 10%, and then 20%, and so on… Then within that same scenarios cut your labor by 10%, by 20%, and so on. Record the results of your dependent variable for each state of the world.
You can see how this all connects in the figure below. We’ve used “Data Table” in Excel to automate the sensitivities in Scenario 3. We could do the same for each scenario. You can also do this manually.
10) Now use your results to:
Most importantly help you understand what your business can take and start making realistic contingency plans for all probable scenarios;
Communicate your sensitivity to your lenders so they can understand what you are going through and what relief you’ll need to get through this (most lenders would rather see you get through this than not – they are much better off if your business lives to see another day and pay them back);
If necessary, you may even want to share this with key vendors to help them understand why you need relief from them.
If you would like the source file for the income statement-only stress test shown above, please reach out. If you have a need to go deeper and include your balance sheet and cash flow statement, let’s discuss how we can assist you. An example of an output table from a full stress test for a larger company with 1) line of credit draw decisions and 2) the need for planning conversations with banks might look like the below: