Updating Financial Projections: 4 Areas Requiring Extra Stress Testing Vigilance

Stress testing has become routine in the financial analysis world. In the finance sector, stress testing has become a part of regulatory oversight, with banks expected to report the results of their stress tests. Non-financial firms might not face the same degree of regulation, but stress testing remains the best way to predict a range of outcomes.

Financial analysts must take many factors into account when projecting company performance. Creating projections and deriving conclusions from them is, however, a tough task, since so much depends on the assumptions an analyst makes. Building some worst-case scenario “what if” analyses into your processes can help a great deal in this regard.

Focusing on a few critical success factors that have a major impact on projections is the best way to minimize uncertainty. Here are four areas analysts should stress test.

1. Volumes, Prices and Costs

When projecting a company's future performance, revenues and margins often hog the headlines. However, these numbers depend heavily on unit sales volumes, pricing strategies, and the cost of raw materials. Often, analysts focus too much on the variance in sales projections but neglect stress testing these key elements that inform sales margins.

Unit sales volumes are essential to stress test since they provide insight into how popular the company's products and services are. This number isn't always listed by companies, especially larger ones. In this case, analysts must focus on prices and monitor any changes the company has made to its strategy.

Examining sales per division and assuming price drops of 5-10% is a good way of projecting final sales numbers under tough conditions. Similarly, stress testing the direct costs of producing the goods sold (COGS) number from the income statement will give analysts insight into how sensitive the company's margins are.

The right analysis tool can reduce the complexity of preparing such projections. For instance, FP&A reporting tool DataRails integrates with Excel, allowing analysts to draw dynamic data from multiple sources that live outside your spreadsheets. Thus, analysts can be rest assured they aren't working on siloed data that will result in inaccurate projections.

When you don’t need to manually import and normalize data into the working environment where you conduct analysis, it becomes far easier to slice and dice data on an agile basis, which is essential when preparing multiple projections and “what if” scenarios.

2. Employee Headcounts

Employee counts are often neglected when stress testing organization results. Analysts tend to focus on costs such as COGS, Capital Expenditures, and so on. SG&A costs tend to go unnoticed since employees don't occupy the spotlight in a financial report.

However, they are a company's most valuable resource. The effectiveness of a company's HR department in hiring and maintaining employee morale cannot be neatly measured with a metric.

In this sense, metrics such as employee turnover and headcount can provide significant insights into how sustainable the company's current projects are.

For instance, if employee turnover increases due to new policies, how will that affect bottom lines? Helpfully, people analytics tools like SplashHR offer built-in calculators that help analysts stress test employee turnover and project its impact on bottom lines. These calculators also take average compensation into account when creating stress tests. 

Employee satisfaction as an issue is only starting to make headlines, and amid the “great resignation,” it is arguably the most important measure of a company's most valuable resource. Monitoring headcounts and stress testing them are thus essential.

3. Exchange Rate Volatility

When analyzing a company with substantial international operations, factoring in currency exchange rate volatility is essential. 

 Often, changes in exchange rates can flatten profit curves. While predicting exchange rates is a hopeless task, thanks to the range of macroeconomic factors that have to be considered, stress testing rates is simple.

Analysts can assume a band depending on the average trading range for a currency pair over a year (or any time frame the analyst desires.) Using the extremes of these trading ranges, analysts can then project the company's profits. Free tools such as TradingView provide plenty of relevant raw data to help with this type of analysis.

 For instance, the Euro has fluctuated between 1.23521 and 1.11857 versus the USD over the course of 2021. Using those extreme exchange rates will help analysts stress test best and worst-case scenarios easily. By projecting international profits like this, analysts can figure out how dependent the company is on its international operations, and whether it is taking any steps to hedge currency exposure.

4. Cost of Capital

Cost of capital is a tough metric to estimate, but it plays a critical role in estimating a company's profits. The cost of debt capital is easy to project, though, since analysts can look at prevailing interest rates on the company's books. Economic changes concerning interest rates are also easy to access, and this makes projecting the cost of debt relatively straightforward.

Calculating the cost of equity capital is a more challenging task. 

Analysts account for this via the CAPM asset pricing model. While the model doesn't directly yield the cost of equity, analysts can derive it by modifying the risk-free rate of return. This CAPM calculator can help analysts create projections quickly and test their assumptions.

Deriving the cost of equity is a tough task, but it helps analysts evaluate the company's attractiveness as an investment. If investment sentiment sours, the higher cost of capital will weigh bottom lines down, impacting investment choices.

Focusing on Extremes

Stress tests are highly valuable as a tool, since they force analysts to look at worst-case scenarios. Often, extreme conditions get ignored due to them being classified as Black Swans. However, as the markets have become more volatile and business conditions more challenging, analysts must account for extreme events more than ever before. 

 The four data points highlighted in this article will create realistic stress tests and better models.