Stress Testing Can Strengthen a Business (Part 1)
Many SMEs have survived the GFC credit crunch, worked their way through the maze of compliance and corporate governance requirements, and then at the start of 2011 were hit with the impact of devastating floods and cyclones.
The recent disastrous Queensland and Victorian floods and North Queensland’s Cyclone Yasi will have a direct and indirect impact on the SME sector that is likely to be felt for many months and even years to come.
Directors have an obligation to be properly informed about the financial position of their company and to ensure it does not trade whilst insolvent.
With SMEs bearing the brunt of the recent disasters, the directors of SMEs should focus on answering this key question: “what is the ability of this business to adapt?”.
For businesses not likely to be affected by the floods, this process of attempting to disaster proof their business as much as possible is still a useful process for directors to initiate.
Stress testing to avoid business failure
To protect themselves and their businesses, directors must ensure their management teams are conducting thorough stress testing, through detailed financial modelling and ‘what if’ scenario testing. This can be done in-house or reviewed by an external advisor.
Stress testing before disaster strikes will help avoid business failure. Directors should be ensuring their management teams are putting initiatives in place to bulletproof their businesses from a range of risk impacts.
Stress testing puts businesses in a stronger position if they need to negotiate with their financiers, by showing they are prepared for change and able to handle challenges.
It also enables directors to act swiftly in response to change, and make wise decisions quickly.
So what is stress testing?
Stress testing focuses on analysing base case and worst case scenarios and provides a number of benefits. These include enabling businesses to react quickly when conditions change suddenly, and clarifying short to medium term capital requirements.
Stress testing also forces business owners, boards and directors to ask ‘what if’ and create strategies to deal with potential scenarios to minimise risk and maximise opportunity.
Effective stress testing
When our Vantage Performance team works with clients on stress testing, we ask them to consider these key questions:
- What is the new break-even sales level for the business, taking into account changed product/services demand and altered supply conditions?
- How would lower demand for products/services impact revenue and earnings?
- Would this translate to lower staffing demand, and what effect would this have?
- Does the business have sufficient cash flow to fund redundancies?
- How low is the board prepared to reduce prices before it becomes unviable to sell the product or service? What changes will need to be made to the cost base to match a lower revenue base?
- How is cash flow impacted if debtors take an extra 10 days to settle accounts?
- Is the business at risk of breaching financier covenants? If so, how will the board respond to financier concerns?
- What changes will be required to finance facilities and how would financiers react to a request for increased lending?
- Which overheads can be reduced and what capital expenditure plans can be put on hold to preserve cash?
- What non-core assets could be sold to reduce debt or provide extra cash flow?
- At what point are sales/production levels too low for the business to remain viable? Is a merger/strategic partnership an option? Who would you approach?
Once the capabilities of the business are assessed, implementing a strategy of continuous improvement will ensure your business is well positioned to take advantage of opportunities.
Vantage Performance is Australia’s leading business transformation and turnaround firm – solving complex problems for businesses experiencing major change.