Pro Tip #12: Stress Test Your Financial Plan
Once you develop your financial plan, your next step is to stress test it to understand which variables are the weak links that could lead to failure and to mitigate these risks.
All of your forecasts are point estimates that are at best your best estimate of what will happen. In reality, this is one of thousands of possible scenarios.
Every financial plan is driven by assumptions on everything from prices, volumes, demand, yields, costs, and a wide variety of both common and business-specific variables. These are almost never a single number. Every one will have a distribution that includes an average, a high, and a low estimate. Some variables with a history of data (particularly commodity prices) can be mathematically defined with a standard deviation, a mean, and a fitted distribution (e.g. normal, logistic, binomial, discrete, Poisson, or dozens of others).
Understand and Stress Test the variables and consequences that can blow up your transaction
These are the five most common variables for agricultural businesses that need to be tested in your financial plan:
- Yields (including the risk of catastrophic failures and insurance risks for crop failures or livestock deaths)
- Customer Demand
- Labor assumptions for time to complete tasks
- Input variables that can inflate costs (e.g. energy costs; inflation rates; interest rates on variable or floating interest rate debt)
All of these impact three critical metrics:
- Cash balance for each period (must be greater than the higher of zero or a minimum safety level)
- Revolving loan balance for each period (must be less than or equal to the amount of the credit line)
- Debt to Equity Ratios (some debt comes with restrictive covenants that prohibit the borrower from exceeding a specified value)
You need to structure your plan so that all three of these critical metrics are true for every period covered in the financial plan.
Use full Monte Carlo Stress Test Simulations when tens of millions of dollars are at stake.
Dynamic simulations give the most insights into the risks of your business plan. These are best for large commodity projects where the variables are well defined and you have good data on both historical prices and all of your major variables. They are less useful for businesses in areas like new technology where consumer behavior and price history are largely unknown. We use Palisade Corporation’s @Risk and Decision Making Suite of Microsoft Excel spreadsheet add-in applications to convert a static corporate cashflow model into a dynamic one. These models can be extremely complicated and can include decision trees and optimizations within the model to handle complex scenarios with multiple embedded real options. Note that this software is expensive (over $3,000 per user) and requires significant Masters degree level of expertise found only in some advanced finance and systems engineering graduate programs. This is time consuming so expect to spend days setting up the model, running simulations, analyzing the results, and making adjustments to your business model and plans before you reach a final model and analysis. Your end goal is to refine your plan such that your business will survive all normal scenarios without a bankruptcy event. Normal here is typically defined as 99% or roughly three sigma events (in the negative direction). However, this will not cover low-probability extreme events such as those that might result from geopolitical events, nuclear war, large scale (unpredictable) natural disasters, major technological changes, or other force majure events.