“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.
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.”
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.