By Kaushik Mitra, Senior Director, Cloud ERP/ EPM Sales, Oracle India
A stifled demand and inefficient monetary policy in the global economy of 2022 have created confounding statistics altogether. New records were constantly being set in almost every category of economic data, including the corporate bond market, IPO volume, stock market, housing market, and M&A activity. Now, the macroeconomic wind is beginning to swing in the opposite direction.
Consumer goods and workers are in short supply all across the globe, but there is uncertainty at large. Additionally, the increased inflation rate is also tightening the profit margins (and stock prices) of companies across industries. Whereas, strict monetary policies, in an attempt of banks to reign in high inflation is making it highly expensive for companies to access capital markets, either through IPOs or new debt issuances. As a result, 2022 is enroute to becoming the weakest IPO market in two decades. The volume of Mergers and acquisitions (M&A) has also witnessed a significant decline.
On the other side, the skyrocketing interest rates make it more challenging for highly leveraged, businesses, consumers, and governments to service their debt, which is leading economists to predict a recession in 2023.
We also saw business challenges emerging more frequently without any warning. Fragile stability and volatility are never more than a crisis away and these last few years have been a reminder of that. In this landscape, scenario planning has become critical for CFOs to navigate through uncertainty. Following are three areas that scenario planning must focus on:
In order to optimize and assess financial health, liquidity is a significant aspect, to begin with. Businesses often need to answer the most critical questions including the capital requirements for the next 1 or half year, the present cash position, the expected cash status in the next 2-3 months, the way to short the cash conversion cycle, the way to optimize the inventory levels as well as the efficient allocation of excess cash generated.
These are arguably the most significant financial questions to be answered and optimized in the near term. Liquidity brings excess cash which can be used for strategic projects, capital expenditures, or perhaps to capitalize on the next mergers and acquisitions opportunity.
2. Finance Structure
Another crucial area is the money structure that has long-term consequences for the performance of the company. In this aspect the significant questions to answer are the weighted-average maturity on outstanding debt, weighted-average cost of capital (WACC), and how is it likely to change in the future. Along with that, evaluating whether the percentage of corporate bonds are fixed or variable-rate, how will rising interest rates affect future cost of capital, whether should businesses raise debt or equity financing, when and how should our leverage ratios compare to other businesses in our industry as well as how to adjust the dividend payout ratio as the business grows.
The capital structure should be refined and adjusted all the time to evaluate economic shifts and external risks. The adjusting of capital structure has certain profound implications for future financial performance and is a decision that must be treaded carefully as its effective application can augment earnings, but it can also amplify losses. Businesses may want to de-leverage to minimize risk and maximize financial strength in a time of high-interest rates and high inflation.
3. Ensuring Profitability
To identify any potential underlying weaknesses, the business model should be re-examined. The critical points to consider are identifying the products and product lines that are most profitable and also the ones which are not, revenue scenarios and its impact on profitability, the impact of an acquisition on the baseline, susceptibility of the business model to changing economic conditions and product pricing adjustment to protect gross margins
When considering changes to the business model, it is crucial to ensure employee wage compensation, product pricing, and running profitability scenarios. Assessing financial impact before acquisitions, mergers and divestitures are equally vital allowing CFOs to analyze potential funding options for the deal, as well as how that might affect cash flow, capital structure, profitability, working capital, and leverage.
Futureproofing the businesses
Businesses can predict future financial health with greater accuracy by constantly analyzing the business model and growth plans. CFOs can make better decisions—faster by modeling the impact of strategic scenarios across the income statement, balance sheet, and cash flow statement.
In a nutshell, scenario planning prepares your business with the tools it needs to be successful, no matter what challenges your business will face in the days ahead.