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Published on March 3, 2020
Modeling to Plan Through a Crisis: The Covid-19 edition
The current coronavirus outbreak has generated a massive impact on the world's economy, and many companies are facing significant challenges, such as a decrease in demand, supply chain disruptions, and workforce shortages. The measures that companies take to mitigate the shocks of a crisis are critical for loss minimization and business continuity. Due to the high level of uncertainty, short-term actions are more important in ensuring the required level of liquidity to keep the lights on, by the time long-term measures can be applied, there might not be a company to save.
The model becomes a tool for crisis planning by using a static setting as a baseline and applying scenario analysis to assess the impact of a black swan event on the company.
Most companies perform regular budget planning, but when there is a major crisis caused by either an external or internal event, a simple budget is not capable to accurately assess the effect of the crisis on the company. A crisis can affect the following variables of a company: demand volume, unit costs, labor prices, rental expense, salary, supply chain capacity, production capacity, and others; sometimes, it will affect several variables at once. For this reason, a financial model that accurately reflects the operations of a business and capable of comparing various scenarios is a potent tool for crisis assessment and developing mitigation measures. This model should include demand and production assumptions as inputs and have financials (income statement, balance sheet, and cash flow) as output.
The model becomes a tool for crisis planning by using a static setting as a baseline and applying scenario analysis to assess the impact of a black swan event on the company. Usually, the effect of a crisis is difficult to estimate due to the fluidity of the crisis itself. The current coronavirus outbreak is no exception. Therefore, the analysis done within the model requires the build-out of scenarios to reflect that uncertainty:
1) "Maximum Reasonable Exposure," which would constitute the worst-case scenario;
2) "Minimum Reasonable Exposure," the best-case scenario; and
3) "Moderate Exposure," the least extreme of all scenarios.
To accurately diagnose how external shocks will ripple through the business, each model must focus on both accurately capturing the causal chains and the proper allocation of resources in the financial accounts. Causal chains, or rather the order of events in a process, should assume the driver of production is demand and not vice versa. When demand subsides, the production quantity linked to it will decrease as well in the model. Keep in mind that production might also be driven by another factor, inventory buffer, so if either factor changes, production must also change.
The greater the level of granularity built into the model, the more beneficial it will be in developing a crisis mitigation plan
Attaching each resource (employee, inventory, equipment, etc.) to the appropriate account of the financials is also essential to building a reliable model. For example, if a company requests employees to take unpaid leave as a cost-cutting measure, the payable salary amount in the balance sheet, and the salary expense in the income statement will both decrease.
The greater the level of granularity built into the model, the more beneficial it will be in developing a crisis mitigation plan. With that in mind, the following are responses that companies might consider in the short-term:
1) Extending days payables - negotiating with suppliers on postponing payment days is generally one of the first actions to take when businesses have low liquidity. If the model attaches all purchases from different suppliers to the corresponding payables, it would be much easier to determine which payables to ask for an extension and for how long. A change in each payment date will be reflected automatically in the balance sheet and cash flow statement.
2) Determining critical components for production - when the supply chain is affected, it is imperative to know how the production cycle will be affected by a shortage of essential materials and components. An efficient model would link the inventory level to the production capacity and sales amount, generating the exact quantity of inventory to source outside of the current supply chain to meet production targets.
3) Optimizing limited production - in the case of limited personnel or raw material, the company should optimize production by prioritizing products with the highest margin and highest opportunity cost. A model where the demand assumptions are the driver of the production quantity, the exercise of optimizing production by prioritizing committed orders (high opportunity cost) becomes effortless.
4) Delaying inventory purchases - this is related to the previous point of optimizing limited production; inventory related to products that are lower in opportunity cost should be postponed to minimized payables and keep cash flow positive.
5) Cutting/delaying costs - a model with accurate costs applied, will help determine what expenses to cut or delay to maintain positive cash flow.
6) Obtain a loan - while nearly impossible for many private enterprises in the past, it may be possible for your business to obtain a low-interest loan for local banks. The exact amount of the loan to request should be calculated after the impact level on all possible variables is considered and modeled correctly.
7) Taking advantage of local outbreak-related subsidies - most cities in China have introduced measures to reduce the economic impact of the coronavirus and subsequent lockdown on local business – including foreign-invested firms.
Jenny Yip
Project Manager - ECFO Services LTD