How to Mitigate Risk in Your Business – and Your Financial Modelling
Effective financial modelling is a powerful tool to help quantify and understand the impact of risk.
Risk is not inherently bad – the danger is that it is mismanaged, misunderstood, or simply ‘missed’.
Areas of uncertainty – risk – vary from business to business, but typically include:
- Reserves of a resource or product
- Project life or product lifecycle
- Exchange rates
- Processing or manufacturing and costs
- Costs of marketing and distribution
- Capital Expenditure variations in both cost and timeframe.
So, how can business risk be incorporated into financial models?
3 Financial Modelling Methods for dealing with business risk
1. Sensitivity Analysis
Sensitivity analysis examines a range of scenarios. It typically focuses on one input and one output – incorporating ‘what if’ and ‘break-even’ analyses to determine the impact a variable has on the key output.
Sensitivity analysis helps manage risk by determining key drivers, exploring what happens if we’re wrong on one or more assumptions and determining a range of likely values.
2. Scenario Analysis
In contrast to sensitivity analysis of one input and one output, scenario analysis examines multiple inputs and outputs. It determines:
- The key outputs in different scenarios.
- How those key outputs are affected by changes to multiple inputs.
3. Monte Carlo Simulation
Monte Carlo analysis simulates the sources of uncertainty that affect inputs, and calculates their impact on likely outputs. It uses multiple sources of uncertainty, and estimates the range of variation in inputs to determine the likely range of key output values.
Sensitivity, Scenario and Monte Carlo analyses are all powerful tools that can be invaluable in helping you understand, manage and mitigate risk in your business.
These are the primary methods used to incorporate business risk into financial models.
But what about the risks associated with the financial modelling process itself?
Eliminating financial modelling risk
A July 2013 report by UK-based financial modeling company F1F9 suggested that 88% of spreadsheets contained errors – and 50% of those used by large companies have material defects.
Therefore, if you’re serious about effectively managing risk in your organisation it’s also critical that you eliminate any risk within your financial models.
6 signs that your financial model needs auditing:
- The model or its results are complex
- The model has been designed, used or modified by more than one person
- The model or its results are used by senior management
- The model and/or its results have significant financial and business implications
- The model and/or its results are released externally
- The model is used for legal or tax compliance purposes.
If you don’t have the auditing capabilities in-house, consider hiring an experienced, independent financial modelling specialist, to ensure your financial models are accurate.
Jeff Robson is the Principal and Founding Director of Access Analytic, a consultancy specialising in financial modelling, forecasting, valuation, model auditing and management reporting.