Factoring Risks into Financial Forecasts and Planning

VUCA, short for volatility, uncertainty, complexity and ambiguity is an acronym used to describe the world we live in.

Since the onset of globalization, CFOs have had to deal with a variety of uncertainties and risks. From the traditional operational, financial, credit and market risks to strategic risks, the list goes on.

Yet despite having knowledge of these risks and how they can derail the company from its successful course, very few CFOs and their teams factor risk management into their financial forecasts, budgets and plans.

As custodians of the forecasting and planning function, it is the responsibility of CFOs to ensure that risks to the operational existence of the business are identified, assessed and properly mitigated.

Unfortunately, regardless of its limitations, some CFOs still rely heavily on the annual budget to drive business performance. A lot has been proven and written on the shortcomings of the traditional budgeting process.

For example, the annual budgeting process is time-consuming and by the end of the first quarter, most of the assumptions used to prepare that budget no longer hold true hence the need to adopt driver-based rolling forecasting and planning.

To successfully take advantage of emerging opportunities and help empower strategy, the Financial Planning and Analysis (FP&A) team must embrace risk-adjusted forecasting.

Instead of focusing entirely on single-point estimates that fail to identify risk exposures, risk-adjusted forecasting enables CFOs to look at possible outcomes and probabilities based on multiple risk variables.

The macroeconomic environment is always changing and as a result CFOs ought to be proactive rather than being reactive.

It is no longer sufficient for CFOs to know what happened in the past. There is need to move on from the traditional cost-variance analysis towards a more forward-looking approach.

Thanks to developments in analytical technologies, through the use of descriptive and prescriptive analytics, CFOs are able to gain insights on why something happened as well as model the future.

In other words, technology is addressing the challenge of preparing forecasts based on gut feel.

Through risk-adjusted forecasting, forecast models can be built that are based on facts such as competitor activity, production activity, regulatory pressures, supply and demand changes etc.

Having an expanded view can help many companies address interconnected risks, some of which may have been previously identified, others that may have gone unnoticed.

Rather than entirely focusing on hitting one set of given numbers, CFOs should stress tests their forecasts and rigorously challenge the assumptions used to create those forecasts by asking the right and hard questions.

This will help identify an understatement or overstatement of risks and take corrective action. Given that growing a business brand and improving revenue growth and operating margins all come with a bag full of risks, if CFOs turn a blind eye and ignore these risks, they definitely are bound to steer their organizations towards an iceberg collision.

Risk types and risk drivers vary by company, business and industry.

Thus, it is critical for CFOs to have an enterprise view of risk if they are to be successful in addressing any material concerns facing the finance function and the organization as a whole.

At the same time, factoring risks into the forecasting and planning processes ensures effective allocation of investment resources based on multiple risk-return positions.

Identifying the various risks the organization is exposed to as well as their drivers requires both a bottom-up and top-down approach.

A bottom-up approach is helps identify, assess and evaluate the risks operating at the shop floor level. A top-down approach looks at the risks of the strategy and to the strategy and how they can be mitigated.

Understanding common risks and how they cascade and interact provides a foundation from which risk-adjusted forecasting frameworks can be developed and then set up throughout the entire organization.

Care must be taken that you get a balance on the number of risks and their drivers based on perceived importance, data availability and practicality. The idea is to get valuable insights that drive effective decision-making as opposed to overburdening the business.