“Risk-adjusted forecasting” is a new buzzword in financial planning and analysis (FP&A). What, exactly, does it mean? “Risk-adjusted forecasting and planning involves shocking the financial forecasts with major risk drivers in an integrated and flexible manner,” says H-K Bryn, strategic risk partner at Deloitte in the U.K. “The approach allows a more robust and transparent evaluation of volatility and risk within current plans, helping to build a better understanding of the potential upside—and downside—inherent in the future of the business.”
Mark Pellerin, a principal at Oliver Wyman, which conducts an annual risk survey with the Association for Financial Professionals (AFP), puts it another way: “When I think of risk, I think about having a clear understanding and definition of the relationships between the variation in expected outcome and risk factors,” he says. “Risk-adjusted forecasting is coming up with alternative forecasts that have clearly defined relationships with the variables and risks.” It’s not about having a crystal ball, but about achieving a better and more precise definition of the drivers of, and risks to, the organization’s financial performance.
“You cannot get away from uncertainty in the world,” Pellerin says. “No matter how precise the prediction, there’s an extreme level of unpredictability” in the corporate planning process, adds Steve Player, managing partner of the Player Group and program director for the North American arm of the Beyond Budgeting Roundtable (BBRT).
Although it can’t provide certainty in its predictions for the future, a risk-adjusted forecast can be well worth the effort. “If you’ve done a risk-adjusted forecast, you can begin having the management intervention discussion—i.e., how do you react if one or more of those risks or opportunities crystallize?” Bryn says. The idea is to get to a more transparent evaluation and business forecasting process at every level to create value-based decisions.
Companies that do this well can respond more quickly to changes in the competitive environment and shifts in the marketplace. Charles Alsdorf, a director with Deloitte, expects that in the near future “one way companies will differentiate themselves is by getting better at understanding risk and bringing that into financial planning.”
How It Works
The best approach for introducing risk-adjusted forecasting into an organization is to start small and build up. For many companies, that means implementing a risk-adjusted approach to a one-off project—such as a divestiture or a large CapEx project—or else rolling out risk-adjusted forecasting to just one business unit. Then, as their first foray is successful, companies can grow their risk-adjusted forecasting capability over time. “This really helps in terms of getting buy-in from management,” Pellerin says. “It shows real benefits along the way, as opposed to trying to make a large investment in overhauling the entire process. This is not a one-time effort. You start with a pilot, select two or three key risks to your organization, and incorporate them into the FP&A process.”
To select the right risks, Alsdorf recommends that companies look to their enterprise risk management (ERM) program. After all, risk-adjusted forecasting sits at the intersection of ERM and FP&A. “Do up-front analytics to identify the variables that would drive changing the business forecast,” he says. He suggests choosing the top 5 to 10 risks identified by the company’s ERM initiative. Bryn agrees; he says that after the first 10 to 15 risks, adding more risks to the forecasting process offers diminishing benefits.
Once an organization has pinpointed the factors that might cause disruptions to its forecast, it’s ready to bring those key variables into the planning process. According to Bryn, the next step is for the company to describe each risk from the perspective of both probability and impact, then put the risks into a simulation model to more precisely project their impacts on cash flow and earnings. (See Figure 1, below.) Following these simulations, the company can prepare for the future by looking at both its base plan and a new risk-adjusted plan. It can use the combination of plans to answer questions such as: How realistic is the budget? What are the key downside drivers to that budget? And what would be the impact on the balance sheet if the company experienced a worst-case scenario?
Ken Hooper, director-advisory at PwC, says the first step beyond basic risk assessment is to create the baseline for the risk analysis. “Once you have that, you can begin to consider how to integrate that into the forecasting process,” he says. “The next step is within the forecasting process itself. You can go with cases: high, base, and low. You can do scenarios about decelerating and accelerating growth.”
Another possible approach is to use what’s called a “pre-mortem” analysis, Hooper explains: “Rather than focusing on the probability of particular risks happening [in the future], assume the future is here and an event has happened. What’s your response to that? Such facilitated discussions [in] the business planning process focus companies, business leaders, and planning groups on how to respond and put a plan in place to prepare for future scenarios.”
In theory, this process should be more manageable for companies that have successful ERM programs, but that isn’t always the case. “Historically, budgeting and planning have been handled separately from the ERM and strategic planning processes,” Bryn says. “These silos of activity didn’t connect, so budgeting and forecasting did not reflect the key risks facing the organization.” Indeed, the 2014 AFP/Oliver Wyman Risk Survey showed that integration of risk and forecasting is the number-one challenge for companies looking to improve business performance.
Of course, a lot depends on the maturity of the company’s ERM program. “At many companies, ERM has become a compliance, rather than a strategic, exercise,” Bryn says. “I’m agnostic as to whether [risk-adjusted forecasting] gets driven by the risk function or by another function. What I’m passionate about is that companies start leveraging the information and their data to drive better decision-making. There’s a lot of untapped value potential in breaking down organizational silos.”
But that’s easier said than done. According to PwC director Michael Chagares, “It’s challenging to get business units to integrate enterprise risks into the corporate strategic planning process. Even ERM leaders often do not integrate their risks into the forecasting process supporting enterprise-wide objectives. I don’t see them connecting the two.”
To What Degree Are Companies Risk-Adjusting Their Forecasts?
According to the “AFP Guide to Demystifying Risk-Adjusted Forecasting,” released in April, more and more companies are incorporating some form of risk analysis into their forecasting and planning. (See Figure 2.) Some of the early adopters come from the pharmaceuticals, energy, and financial services industries. Still, few organizations have perfected the process.
“There are companies that do ERM really well and companies that do forecasting really well, but there’s very little overlap in companies that do both,” Chagares says. “What we would suggest is that this is a multi-stage process; it can’t be done overnight. It requires first building up the level of ERM maturity, before you layer in the forecasting process. It’s a two-cycle implementation.”
Adds Larysa Melnychuk, director of the London FP&A Club, “The risk-adjusted planning process is still in an embryonic state in many organizations.” Very often, forecasts incorporate risk scenarios that are triggered by high-level assumptions and judgments rather than carefully defined risk drivers. And most companies use sensitivity analysis, scenario planning, and a method of discounting net present value (NPV) to come up with their potential outcomes. “Risk-adjusted probabilistic approaches—like VAR [value at risk], earnings at risk, and cash at risk—are still very new concepts for FP&A professionals,” she says.
In fact, says Hooper, “basic forecasting and budgeting processes in many companies have not changed in decades. It’s interesting that in the 21st century we are still using business forecasting techniques developed in the 1950s. Integrating a risk management approach into your planning process can provide the foundation for managing, monitoring, and reporting business decisions.” And that’s a goal risk managers, FP&A, and all the business’s other leaders should be able to unify behind.
Nilly Essaides is the director of practitioner content development at the Association for Financial Professionals (AFP). She’s been writing, researching, and speaking about key themes in corporate finance and treasury for over 25 years.