demystifying risk-adjusted forecastingforecasting and how teams can begin to transform their finance...

AFP® GUIDE TO

Demystifying Risk-Adjusted ForecastingFP&A Guide Series

Issue 4Sponsored by

AFP® GUIDE TO

Demystifying Risk-Adjusted ForecastingFP&A Guide Series

ContentsExecutive Summary 1

Sidebar: What Does Risk-Adjusted Forecasting Mean? 1

Introduction 2

Interaction with ERM 3

Sidebar: Interaction with ERM 4

Sidebar: What Makes a Successful ERM Program 6

Case Studies 8

Case Study 1: Oil and Gas Exploration and Production Company 8

Case Study 2: E-commerce Company 9

Case Study 3: Energy Company 10

Case Study 4: Healthcare Provider 11

Case Study 5: Restaurant Chain 11

Case Study 6: Insurance Company 12

Case Study 7: Consumer Electronics Manufacturer 13

Case Study 8: Small Energy Company 14

Conclusion 14

Sidebar: Risk-Adjustment Forecasting Best Practice Checklist 15

Sponsored by

Dear Financial Professionals,

As the business landscape changes, so does the need for higher quality data and insights into all possible risks and opportunities that impact a company’s ability to maximize returns while minimizing risks.

The 2014 AFP Risk Survey shows that the integration of risk and forecasting is the single largest challenge for companies looking to improve business performance. With this in mind, Workiva is pleased to partner with the Association for Financial Professionals (AFP) to produce this guide to risk-adjusted forecasting.

This guide provides a critical definition of how companies benefit from risk-adjusted forecasting and how teams can begin to transform their finance function to add even more value to the business planning process.

Successful implementation of integrating risk factors into your financial forecast begins with a critical evaluation of and change in internal processes and communication between FP&A and risk management teams. This transformation begins by:

• Focusing on moving separate FP&A and risk management processes to joint efforts incollecting key finance and risk inputs, allowing teams to develop shared data sets of themost important and relevant data impacting your business

• Developing a platform that facilitates collaboration between teams to develop a commondefinition and set of assumptions of the key risks that most affect the business, leading toa better understanding of the possible outcomes based on those defined risks

• Coordinating FP&A and enterprise risk reporting to management and the board, whichimproves the quality and consistency of data and analysis that ultimately providesmanagement with the insights and analysis that inform better strategic decisions

Companies have technology and consulting partners who can serve as strong allies to facilitate this critical financial forecasting transformation. It can be challenging to implement new processes to link risk to forecasting and planning, but advanced technologies can make this transition possible with the speed and control necessary for successful deployment. It will benefit companies to explore new technology that will facilitate the integration of FP&A and risk management and make teams more self-reliant to achieving or exceeding enterprise-wide objectives.

Joe HowellCo-Founder and Managing DirectorWorkiva

www.AFPonline.org ©2014 Association for Financial Professionals, Inc. All Rights Reserved 1

AFP GUIDE: Demystifying Risk-Adjusted Forecasting

Executive SummaryRisk-adjusted forecasting is a term increasingly used by risk management and finance consultants. In the past few months, there’s been a virtual avalanche of articles and publications replete with flow charts and complex risk models that aim to show companies how to integrate risk into their forecasting process. These reports look great, but do companies actually use these approaches in their daily operations? AFP research shows the implementation of risk-adjusted forecasting is still in its embryonic stage. Very few organizations have actually adopted a textbook framework, implemented sophisticated modeling archi-tecture, or fully integrated their risk and their financial planning and analysis (FP&A) functions.

That is not to say companies do not adjust their fore-casts for risk. Interviews with over a dozen experts and practitioners demonstrate that many companies already look at various risks that could affect the delivery of their plans, and they incorporate one or more of these variables into their forecasting and planning process. They just don’t put the risk-adjusted label on the process, and they don’t use fancy models and quantitative analysis. Instead, they prefer high-level views of what variables and risks may impact performance.

So, while adjusting for risk still involves a fair amount of guess work, at least companies are beginning to link risk to forecasting and planning. And plenty of them are moving up the maturity scale. The 2014 AFP Risk Survey conducted in collaboration with Oliver Wyman focused on how risk management is integrated into the financial planning process. The study findings show that increased risk and unpredictability in the business environment is causing a greater focus on the intersection between FP&A and risk management. According to the survey results, over 90 percent of senior financial executives consider risk management extremely or very important.

“Leading companies are focusing on collaboration be-tween FP&A and risk management to improve the qual-ity of finance and risk inputs from a variety of business units in order to provide their executive teams with better business insights for strategic planning and forecasting,” the report states.

What Does Risk-Adjusted Forecasting Mean?

Ken Hooper, PwC: A forecasting approach that incorporates ranges of assumptions and forecast outputs to provide a greater understanding of risk factors and potential mitigating strategies.

Mark Pellerin, Oliver Wyman: Risk-adjusted forecasting is establishing a clear relationship between financial results and the variables that impact or drive performance.

H-K Bryn, Deloitte: Risk-adjusted forecasting and planning involves shocking the financial forecasts with major risk drivers in an integrated and flexible manner. The approach allows a more robust and transparent evaluation of volatility and risk within current plans — helping build a better understanding of the potential upside and downside inherent in the future of the business

Charles Alsdorf, Deloitte: Risk-adjusted forecasting is an emerging method for providing senior management with more insights about the leading indicators and drivers of future business performance, how those indicators are evolving in an uncertain world, what that uncertainty is doing to actual and projected business results, and what course-directions (i.e., operational flexibility) management might undertake to enhance results.

2 ©2014 Association for Financial Professionals, Inc. All Rights Reserved www.AFPonline.org


Introduction“The risk-adjusted planning process is still in an embry-onic state in many organizations,” said Larysa Melnychuk, director of the London FP&A Club. “However, many companies continue to play different risk scenarios dur-ing their planning or forecasting processes.” Very often, risk scenarios are triggered by high-level assumptions and judgments rather than carefully defined risk drivers. Most companies then use sensitivity analysis, scenario planning and a method of discounting net present value (NPV) to come up with their potential outcomes.“Risk-adjusted probabilistic approaches, like VAR, earnings at risk and cash at risk are still very new concepts for FP&A professionals,” she said.

This more advanced concept of risk adjustment “is arguably in front of the market,” agreed Charles Alsdorf, director at Delloite. “For the most part business leaders are not there, and business systems are not yet enabled to perform the analysis, although we’re starting to see movement toward incorporating risk into forecasting systems in the software space,” he said. “More companies are working to integrate their risk and financial planning and analysis process, and to look at multiple variables when creating their forecast and plan.” (See chart below.)

The benefits of greater integration of risk and FP&A include being able to more quickly respond to changes in the competitive environment and shifts in the market-place. “Given the increase in risk, that suggests that one way companies will differentiate themselves is by getting better at understanding risk and bringing that into the financial planning process,” Alsdorf said.

“When I think of risk, I think of variability from expected outcome in either direction,” said Mark Pellerin, principal at Oliver Wyman. “I think about having a clear understanding and definition of the relationship between the variation in expected outcome and risk factors. Risk-adjusted forecasting is coming up with alternative forecasts that have a clearly defined relationship with the variables/risks.”

Pellerin is quick to note that adjusting for risk is not about forecast accuracy. “Risk-adjusted forecasting is not about having a crystal ball. It’s about defining the rela-tionship between financial performance and risk/drivers at a high level of precision,” he said. “In many cases the relationships are not linear since multiple risks are inte-grated. There’s no question companies can benefit greatly from integrating these two processes (see chart below), particularly in driving strategic decisions.”

FP&A Employment of Risk Analysis on a “Regular Basis” (Percentage Distribution)

All

FP&A

0% 20% 40% 60% 80% 100%

48%

50%

29%

33%

23%

17%

Yes Occasionally, not on a regular schedule

No

Decision Making Process to Benefit Most from Risk Adjusted Analysis(Percentage Distribution)

All FP&A

36%

50%

40%

30%

20%

10%

0% Strategic Forecasting Financial Capital Operational M&A and Legal/ planning compliance planning allocation/ excellence due diligence Contracting Budgeting valuations

40%

19% 18% 16% 15%10%

8%10%

7% 7%10%

2% 1%

Source: Oliver Wyman/2014 AFP Risk Survey



AFP GUIDE: Demystifying Risk-Adjusted Forecasting AFP GUIDE: Demystifying Risk-Adjusted Forecasting

While more companies are adjusting for risks in the fore-casting and planning process, “the concept is not progressing as quickly as I would have expected,” Pellerin said.

There are several reasons why the concept is not taking off very quickly:

• Forecasting at many companies remains an annual process that doesn’t allow for dynamic risk

adjustment, according to Pellerin.• “Both FP&A and risk management are viewed as cost

centers, so it’s hard for finance professionals to show a positive ROI for investing in processes and tools that are only now becoming available and that are expensive,” said Pellerin.

• And, “basic forecasting and budgeting processes in many companies have not changed in decades,” said Ken Hooper, director-advisor at PwC (see AFP Forecasting Guide at www.afponline.org/guides/). “It’s interesting that in the 21st century we are still us-ing business forecasting techniques developed in the 1950s. Integrating a risk management approach into your planning process can provide the foundation for managing, monitoring, and reporting business

decisions with ‘eyes wide open.’”

Steve Player, managing partner of the Player Group and program director for the North American arm of the Beyond Budgeting Roundtable (BBRT), is skeptical of the term that’s being thrown around. “The underlying fundamental reason is that you cannot get away from uncertainty in the world,” he said. “No matter how precise the prediction, there’s an extreme level of unpredictability.”

Interaction with ERMAt its highest level, risk-adjusted forecasting is about the intersection between enterprise risk management (ERM) and FP&A. In companies where the two are integrated, FP&A can add tremendous value by analyzing the relationship and advising management of the impact of different risks on business performance. “We’re now starting to see companies play around with a risk-adjusted forecasting approach,” said Charles Alsdorf, director at Deloitte. “Some of the early adopters include pharma-ceuticals, energy and financial services companies. It’s the integration between ERM, FP&A and forecasting, with the goal of identifying how key risks affect the forecast.”

“Historically, budgeting and planning have been handled separately from the ERM and strategic plan-ning processes,” said H-K Bryn, strategic risk partner at Deloitte in the United Kingdom. “These silos of activity didn’t connect so that budget and forecasting did not reflect the key risks facing the organization. Risk-adjust-ed forecasting is bringing those identified risks into a shorter planning or long- term strategic process.”

“The idea is to get to a more transparent evaluation and business forecasting process, and at every level to create value-based decisions,” Bryn said. “If you’ve done a risk-adjusted forecast, you can begin having the man-agement intervention discussion: i.e., how do you react if one or more of those risks/opportunities crystallize?”

The AFP/Oliver Wyman survey shows that the integra-tion of risk and forecasting is the number one challenge for companies looking to improve business performance.

Primary Challenges to Organizations’ Ability to Forecast Metrics (Percent of Organizations)

0% 10% 20% 30% 40% 50%

42%

38%

37%

29%

29%

22%

20%

Integrating risk and forecasting data to strategic decision making

Capturing relevant data from within the company

Forecasting and analytical skills in organization

Capturing relevant data from external (non-company) sources

Corporate resources

Corporate IT resources

Executive management support for forecasting




“The intersection between ERM and financial planning is where we talk about what risks may affect outcomes and the alternative outcomes based on those defined risks,” Pellerin said. “It has to be somewhat of a joint process. That’s where FP&A can add value.”

The objective is not to produce a fancy report but to “improve the strategic performance of the business,” Pellerin added. “The role of ERM in this is providing recommendations and ideas for mitigating the downside variation and coming up with ideas and strategies for capturing more upside risk. That’s where ERM is linked to business risk.”

Of course, a lot depends on the maturity of the company’s ERM program. “At many companies, ERM has become a compliance rather than a strategic exercise,” Bryn said.

Interaction with ERMAccording to Oliver Wyman’s Pellerin, it’s important to define the intersection between ERM and FP&A for the following reasons:

• Any discussion of deviation from an expected outcome is a risk discussion.

• Joint processes around the exchange of information are important. This includes:

- Use-shared data sets- Relying on common sets of assumptions,

shared definitions and nomenclature for risks and scenarios

- Coordinating reporting by FP&A and ERM for the executive team or the board

- Utilizing ERM to provide recommendations for mitigating downside variation

- Asking the business to develop ideas in order to capture more upside variation

- Leveraging ERM to help the business make decisions that generate the most attractive

risk-return trade-off, maximizing the reward-to-variability ratio (Sharpe ratio)

- Conceptualize starting with normal distribution of outcome, then use ERM to

cut down the left side and maintain the upside to create a positively skewed

distribution (i.e., a more attractive payoff)

The first step is to create the right risk-development process. It doesn’t have to include a formal ERM depart-ment. “I’m agnostic to whether or not they get driven by risk function or another function. What I’m passionate about is how they leverage the information and their data to drive decision-making,” Bryn said. “There’s a lot of untapped value potential in breaking down the organizational silos.”

“We’re both big believers in the importance of incor-porating ERM with business planning, forecasting and strategic planning,” added Hooper. “While the concept makes perfect sense, there’s not a lot of intersection between ERM and forecasting in most companies. Risk information or plan information is sometimes shared, but rarely do companies try to formally integrate those two processes and related initiatives.”

Another stumbling block is that the complexity of each individual risk often makes it difficult to translate into the forecast. “It may be that the risks are more qualitative in nature, or so complex that high, medium and low rating categorizations are inadequate. Addition-ally, many companies don’t have the capability to do complex risk modeling, recognizing the relationships between individual risks,” Hooper said.

Indeed, for many companies, according to PwC Direc-tor Michael Chagares, “it’s challenging enough to get busi-ness units to integrate enterprise risks into the corporate strategic planning process. But even ERM leaders often do not integrate their risks into the forecasting process supporting enterprise-wide objectives. I don’t see them connecting the two,” he said. Even though, according to AFP’s survey, there are multiple benefits to integrating the risk and FP&A functions (see chart next page).

According to Alsdorf, where people can find quick wins is in using shared risk assumptions in the ERM and fore-casting processes. “One key element is whether there’s a process in place to at least have a common set of assump-tions around the performance of the organization that is used throughout the risk management and planning func-tions,” Alsdorf said. “Whether you do this through fancy analytics and software or mental exercise is irrelevant is less important as long as you’re using a common set of handful risk scenarios through the planning process, which are defined through the ERM function.”

In some cases, companies have made the leap to



formally incorporate ERM into the strategic plan-ning process, according to Hooper. “Even where major scenario themes are addressed within the planning process, translating that into a forecast based on range of individual enterprise risks is a rare thing, typically due to the complexity of the modeling. You really have to have an organization that’s willing to improve its risk manage-ment capabilities,” he said. Utility and energy companies who tend to look at strategic and risk projects and incor-porate those factors into the forecasting and planning are taking the lead on this.

According to Hooper, in order to move forward, a com-pany needs a multifaceted commitment, which requires a greater degree of sophistication for the entire risk manage-ment process, before you get to the forecasting elements. To date, a lot of companies don’t have the first part done. “There’s a lack of understanding about the individual risks, risk causes and risk interrelations,” he said.

So the first step beyond basic risk assessment is to create the base of the risk analysis. “Once you have that, you can begin to consider how to integrate that into the forecasting process,” said Hooper. “The next step is within the forecast process itself: you can go with cases — high, base and low. You can do scenarios about decelerating and accelerating growth.”

Benefits of Better Coordination Between FP&A and Risk Management (Percent of Organizations)

Improved quality of finance and risk inputs from across business units

Consistent business/market assumptions

Improve the consistency of data used for risk and FP&A analysis

Improved ability to communicate risk-adjusted financial plans to executive and Board

Ability to add greater value to business

Develop and enhance analytical capabilities within risk and FP&A

61%69%

57%64%

56%65%

53%60%

47%53%

45%54%

All FP&A

30% 35% 40% 45% 50% 55% 60% 65% 70%

“There are companies that do ERM really well and companies that do forecasting really well, but very few that do both,” Chagares added. “What we would sug-gest is that this be a multi-stage process; it can’t be done overnight. It requires building up the level of ERM maturity before you layer in the forecasting process. It’s a two-cycle implementation.”

One global company Chagares worked with has developed and implemented an ERM program over the past 11 years. “They’ve fully integrated a customized risk management framework that is highly qualitative (by design) into their business and operational planning across business units, geographies, and products,” said Chagares. “They review the business and operational ob-jectives and challenge their cross-functional teams to ask: ‘What are the risks that affect each objective and how have our mitigation activities and action plans positively impacted the achievement of that objective?’ They rate each of those objectives based on the analysis of all of the risk mitigation efforts that align with that objective and update them based on a color scheme: green, yellow or red, depending on the level of readiness.”

As a result of this of process, “they have consistently enhanced their confidence level and reduced the un-certainties in achieving their operational and strategic




objectives,” Chagares said. The company’s risk manage-ment efforts have been a key driver for becoming the market leader in its two major product categories.

Too often, ERM is only focused on protecting the downside. But risk is a two-sided coin; it also creates op-portunities, according to Pellerin. “What you’re really to do is maximize business returns while minimizing risks, which is the role of ERM,” he said. By linking ERM and FP&A, “FP&A can help the business make value-add decisions to generate the most attractive trade off. No decision is going to be risk free. The role of FP&A is to provide the analytical horsepower to help inform the business on the variability of outcomes based on risk and drivers.”

The risk-adjusted forecast is not just about mitigating the downside, according to Bryn. “It will also provide management with a line of sight into the available upside and how to possibly capture that risk/opportunity. It leads to a different dialogue,” he said.

What Makes a Successful ERM Program?According to AFP’s CTC Guide to Enterprise Risk Management: Practitioner Perspectives on ERM, many companies are revamping their ERM programs after earlier disappointments. While approaches to the specific program vary by com-pany, leading ERM practitioners exhibit several or all of the following differentiating factors:

• They connect risk and strategic planning.

• They think about risk as having a downside and an upside.

• They put numbers around risk.

• They consider risk capacity.

According to Peter Frank, partner at PwC, wheth-er there’s a formal ERM program is a separate question from whether a company is successfully managing its risks. Some companies have very sophisticated risk cultures and do not necessarily overlay those cultures with an explicit ERM pro-cess. “The companies that do [ERM] well have to combine a cultural appreciation for risk with rigor of process,” noted Frank.

How risk-adjusted forecasting can workThe best approach is to start small and build from

there. Ideally that means implementing a risk-adjusted approach to a one-off project (e.g., divestiture or a large CapEx project) or to one business unit, and then build up the capability over time, Pellerin advised. “This really helps in terms of getting buy-in from management,” he said. “It shows real benefits along the way, as opposed to trying to make a large investment in overhauling the en-tire process. This is not a one-time effort. You start with a pilot, select two or three key risks to your organization and incorporate them into the FP&A process.”

According to Bryn, companies need to:

• Describe each risk from a probability and an impact perspective.

• Avoid trying to incorporate 100 different risks. After the first 10 or 15, the marginal benefit of adding more is reduced.

• Put these 10-15 relationships into a simulation model to derive some cash flow or earnings distri-butions and start looking at a couple of difference aspects — the base plan and the risk-adjusted plan.

• Ask the right questions: How realistic is the budget? What are the key downside drivers to that budget? What would be the impact on the balance sheet if the company experiences a 1-10 worst case scenario?

The first thing you need to do is describe the risk in order to model it. “You need to go through the process for each key risk that you are seeking to incorporate into your risk-adjusted forecast,” said Bryn. Also, companies should look at a combination of risks (aggregate risks) with high impact or high probability versus continuous business exposures. Those risks will vary by industry. In mining, for instance, these risk factors may incorporate labor relations, commodity price risk and business inter-ruption risk or even sovereign risk. “The range of risk will vary between different organizations driven by in-dustry and operational set up of that business,” she said.

Added Alsdorf: “Part of what we’re sensing is that companies make a distinction between big strategic risk and the more operational risks that can often be more easily talked about, categorized and measured. The big



strategic issues that can disrupt the business model tend to be less methodically captured.” Given the focus, there needs to be a change in what goes on in the traditional planning, forecasting and budgeting process. “Executives generally claim dissatisfaction with the quality and pre-dictability of their forecast, but do not necessarily know how to improve it,” he noted.

To make the process practical, Alsdorf advised com-panies to focus on the top 5-10 risks identified by their ERM program. “Do up-front analytics to identify what the variables are that would drive changing the business forecast. Then model how those risks could affect per-formance,” he said. But number crunching is only part of the equation and for many companies is still a ways away. He recommended doing some white sheet think-ing to pinpoint the factors that could cause disruption in the forecast, and then focus on those key variables in creating the business outlook.

“This is not a mechanical exercise,” Alsdorf added. “What really makes it beneficial is building in a learning loop.” The idea is to look at the risk variables that could cause the company to over- or under-perform its forecast and come up with contingency plans to handle either scenario. “The real value of risk-adjusted forecasting is preparing the company to be much more dynamic,” he

said. “The question is: How do I more quickly identify changes in the marketplace? The ability of the finance function to be more nimble in managing and responding to risk is the real benefit of a risk-adjusted forecasting ap-proach,” he said. “It doesn’t need to be overly complex, but it requires a change in thinking and building the tools and discipline.”

“One of the possible responses to the risk complexity issue is to focus on facilitated sessions doing individual scenarios,” PwC’s Hooper suggested. This is also called pre-mortem analysis. “Rather than focusing on the probability of particular risks, assume the future is here and an event has happened. What’s your response to that? Such facilitated discussions force companies, business leaders, and planning groups to focus on how to respond and to put a plan in place as to how to prepare for future scenarios.”

Very typically, companies only take a single variable into account when looking at forecasting variability, but history tells us that it takes more than a single variable to accurately anticipate performance. “We know from all the research that risk happens in aggregate,” Bryn said. “You need to look at it from a holistic perspective regard-ing what would affect the deliverability of the plan. It’s a way to integrate multi-risk perspectives into your financial planning process.”

All FP&A

Risk Metrics and Models Used by FP&A(Percent of Organizations)

90%

80%

70%

60%

50%

40%

30%

20%

10%

0% Scenario Sensitivity Net Risk- Capital asset Value Monte Organization’s Real analysis analysis present adjusted pricing at risk Carlo beta options value cost of model simulations capital

69%

80%

64%

75%

61%66%

35%

41%

26%

31%

24% 25%

13% 14% 13% 14%11% 11%




Case StudiesConversations with FP&A practitioners reveal a wide range of approaches to managing the risks to the forecast. Many remain qualitative and ad hoc. But the case studies also demonstrate that companies in different sectors are looking at the variables that can impede the delivery of their plan and their financial and business performance, regardless of the label.

East). That risk is taken into consideration from the ear-lier stages of business planning in those countries where the company already does business. When considering investments in new countries, “we assemble a multifunc-tional team of people within the company to discuss all the components below ground [engineering] and above ground [infrastructure, political risk] that could affect results,” he explained.

There may also be currency restrictions, requirements to sell locally, or caps on prices. Those risk factors are taken into account when arriving at the economics of the project, using both qualitative and quantitative fac-tors. They then become embedded in the forecast, and the multifunctional teams continue to affect the process, for example, do they think a port might be closed off during the quarter, and how would that impact the vari-ance of outcomes?

According to the manager, once the decision to invest is imminent, the questions become: “What would be the impact on operations? What’s the additional cost? Will there be a deliverable?” That sort of forecasting is handled by the country manager whose responsibility it is to ensure that things go according to plan. “That risk is not explicitly part of the forecasting process,” he said. However, “we run a number of scenarios using statistical analysis.”

There’s no explicit integration among risk factors in investment decision-making and business planning with ERM; that’s a separate process run out of treasury. “The ERM and forecasting are separate,” he said. “Our ERM group will talk to each of the planners and operating people in the various business units. They’ll get their

Case Study 1: Oil and Gas Exploration and Production CompanyThe company incorporates production variability and price risks as both the top risks and macroeconomic factors that could drive its performance, although it does not formally integrate ERM with the business planning process.

>This global oil company has production properties worldwide, with a concentration in the United States and Western Europe. Each operating team comes up with oil and gas production forecasts for each field, from a technical and engineering standpoint, over the next 20+ years. “Just how much oil and gas will be produced is the single most critical risk element in our business,” said the manager of planning and strategy. That pro-duction forecast is overlaid with an operating expenses forecast. The forecasts from all the fields then rolls up through Hyperion to the top, primarily with an empha-sis on the next five years, in addition to any approved capital projects.

The other big risk or driver of performance is, of course, price. In order to be able to compare projects across locations, there has to be a consistent price as-sumption across the organization. “We set a price at the time we initiate the planning cycle,” said the manager of planning and strategy. However, while commodity prices move all the time, the company rarely hedges significant volumes, except under unique circumstances.

To incorporate risk into the forecast, like others in its industry, the company looks at ranges of production lev-els rather than fixed numbers. “We talk about a range of production and production growth rates over 3-5 years, not much further at a range of confidence intervals,” he said. “We do not give price guidance to our inves-tors. The financial institutions are much more adept at providing price data.”

The company takes into account other risks, such as political conditions outside the U.S. (e.g., the Middle



assessment of all the risk and deliver to the Board what’s required for them to have a view on risk — it’s a list of the top risks that the Board needs to be worried about. For our big operating units, the top risks make it to the top of the ERM list. Some of them may not; they may be unique to a unique geography. Some of it is top down risk, like reputational risks, particularly in countries where corruption is rampant.” Overall, “we think of about 5-7 risks to worry about. We look at a number of things, for example regulatory risk around fracking. That’s a huge risk. That’s a big part of our growth.” This is an area where ERM and forecasting intersect. “It’s a place where the operating teams will be directly affected by the risk. “They can tell you how much it costs, what the existing regulations are, what kinds of things would prevent us from doing something economically, how

we’d react, and the probability,” he said. “We also bring in our government affairs group.”

“Similar in approach to above-ground risk and ERM is when we look at new countries and do this qualitative approach and back it up with as much data as we can,” the manager said. “Where we have specific risks and we want to quantify the order of magnitude of the effect on the company, we use the output of the planning process to do sensitivity analysis.”

“In terms of risk, you almost disconnect from bottom up and take a top down approach [regarding] the major risks that affect us. It’s more a rule of thumb, not very scientific,” he admitted. “As we look at new business op-portunities, we manage the risk in terms of incremental decisions of where to invest. Not necessarily new areas, but how rapidly existing areas will grow.”

Case Study 2: E-commerce CompanyBy looking at key drivers and risks, this organization develops a rolling 24-month forecast that is adjusted constantly to reflect changing conditions, using sensitivity analysis.

>“In forecasting and budgeting terms, we look at drivers of top-line growth and revenue and trends in variable cost as a portion of that revenue,” said the head of finan-cial planning and reporting. With those inputs, “you can create dynamic rolling forecast for the business,” he said. “We use rolling forecasts to identify early warning signs regarding performance vs. expectations.”

The major outside risk factors are those that drive visitors to the company’s website, and then convert those visitors into buyers. That means macroeconomics, changes in technology, as well as factors such as country risk. FP&A watches all of those and others. “If there’s turmoil in Egypt on one day, that will affect customer behavior in predictable ways,” he said. ”If we see a downward trend or higher risk we can makes changes like technical improvements or additional marketing (e.g., discounts).”

“If you can identify your key drivers and risks, you can pretty accurately see what’s affecting the top line,” he

added. “The rolling forecast drives continuous improve-ment. In fact, the forecast and the risks are assessed on a daily basis. There’s no stand-alone ERM function that collaborates with FP&A. I see it pretty much as part of my job.”

The company benefits from the troves of data generat-ed by its business to run various analyses and statistical, predictive models to improve forecast reliability. “If you pick and measure the right things, and monitor the right risks, then you have a better risk-adjusted forecast,” said the FP&A chief. “I see risk as something I take into con-sideration in doing planning and analysis. It’s not part of a formalized process or part of my job description.”

“When using sensitivity analysis,” he said, “companies can diffuse risk by identifying and measuring the cor-rect drivers of their business and where the greater risks may reside. But if you take risk into account, you better understand your business.”



At the higher level, “we look out well past our five-year plan for our strategic plan,” said the head of FP&A at the company. The risk component of that process includes an evaluation of the business environment and anything that might change and affect the strategic outlook. That process is not conducted annually since it requires a very elaborate, company-wide effort. “We complete the process every other year or so, and in off years if something changes in the business environment,” he said.

One layer down, there’s a yearly financial plan that projects out over five years. That outlook is very detailed from a financial statement standpoint, and includes fore-casts of the income statement, balance sheet and state-ment of cash flows, with some analysis of the risks that could impact the business over that timeframe. At that level, risk is evaluated in terms of “the potential variabili-ty in our business — both upside and downside — look-ing at multiple risk factors, from tax issues to changes in FX, commodity prices, inflation, and other macro factors, as well as business issues, such as what assets we may end up selling,” he said. “What we’re attempting is to integrate the variability of income statement and cash flows into the core financial planning.”

With regard to the 12-month forecast, the company reforecasts mid-year to adjust for any changes in the

environment and its performance. While the bulk of its revenue comes from regulated utilities, it does take on new projects. For example, if the company is planning on launching a new project, it looks at how that would that affect the forecast over the next 12 months, through the financial plan and strategic plan horizons. The com-pany develops a base case for the project and then inte-grates risk into the cash flow analysis. “There are usually very specifically identified risks that we develop when analyzing our investments rather than, for example, as-suming that construction costs might go up or down by 10 percent. We then incorporate the cash flow impact that these detailed risks might have into our cash flow analysis,” he said. Based on the scenario and probability analysis, “we put together the expected returns.”

Where new change is happening is in integrating the ERM process (which is under the treasurer) more tightly into the forecasting and planning processes. Right now the two are handled in isolation. “We’re in the process of fully integrating our processes to incorporate risk management through the financial plan,” he said. While the first step would be to look at ERM on a project-specific basis, in the future, this FP&A professional expects to look at risk more holistically when running the discounted cash flow analysis for the forecasting and planning processes.

Case Study 3: Energy CompanyThe company relies on a qualitative approach to incorporate risks into its short-, medium- and long-term outlooks, and reforecasts mid-year to adjust for changes in the performance expectations. It’s now beginning the process of linking ERM to FP&A.

>



At this healthcare provider, customer service has developed an approach to managing the primary risk that affects its per-formance: whether new members enter the system or there’s a slowdown in the addition of new customers. “We forecast on a monthly basis,” said the finance director. “We have a financial analyst who supports the operations manager.”

The company uses a modified rolling forecast ap-proach. “We look at the end of each subsequent year, so each month they look out on a 22-month forecast to the end of the next year. My team rolls it up into our busi-ness unit. All the business units submit their forecasts into the holding company at the corporate level. While the forecast is rolling, the budget is set annually.”

The customer service operation he manages takes a multipronged approach to risk. “At the BU level, our risk factors are what could happen to our performance and workforce in case we have an influx of subscribers — or a drop,” he said. “Were that to happen, we could decrease or increase spending vis-à-vis the budget.”

“We have a formal template to take those risks into ac-count,” he continued. “The template lists possible events and the probability of outcome, and then the ‘play-book’ in terms of impact on headcount and results. We quantify it as much as we can and look at that upward risk during our planning forecast,” he said. “Of course, a slowdown in membership is also an option.”

Case Study 4: Healthcare ProviderFor this major healthcare company, the key risk is outperformance, i.e., adding more users than expected. By incorporating upside and downside event scenarios into its forecasting process, it can come up with mitigating business plans.

>

“There’s no perfect solution to incorporating risk into the forecasting process,” said the senior director of strat-egy and finance at this organization. For every company, “there are different levels of risk and types of risk.” Those risks fall into two categories: internal and external.

Internally, the risk is about the ability to execute the plan. “The volatility of that risk is relatively low and can be predictable based on historic trends,” he said. But ex-ternal risk is a lot harder to foresee and can have greater impact. “The more significant risk is less predictable, more impactful, and less frequent,” he said, for example macro risk, such as the events of 2008.

For this organization, as well as many other public companies, the forecast affects the guidance the com-pany provides about its earnings trends. To account for unforeseen risks, “we take a range approach.”

Case Study 5: Restaurant ChainTo determine future business performance, this company takes a “range approach” to incorporating internal and external risks and focuses on probable risks in order to come up with a “Plan B.”

>In this industry, the biggest driver of earnings is com-

parable same-store sales. To come up with a forecast, the company looks both internally and externally at industry and macro environments, such as the economy, competi-tion and food inflation.

“Inflation in the price of food would also affect our cost number,” he said. That’s another risk factor they take into account. To hedge that risk, the company contracts out one year for raw input. “That creates predictability vs. the plan. In addition, there’s a quarterly meeting with the pur-chasing department to assess trends in the market to come up with other risk factors, so we can understand what the pluses and minuses are,” he said. “The cost of input is the next biggest variance where we see volatility.”

Change in labor laws is another risk factor that would affect the industry, and it falls under the category of



external factors at both the macro- and micro-level. “We try to stay up to date on those external, federal, local, or macro risks on the labor side,” he said. “That’s a signifi-cant part of our P&L.”

As the company comes up with its assumptions, he said, “We take all those factors into account to come up with where comp sales may come in and develop a range around that.” The range allows for incorporating macro and micro risks. However, “the reality of the industry is that once you have a good handle on comp sales you can get very confident about the rest of the P&L.”

To prepare for any significant risks, finance meets with management on an annual basis to review the ranges and come up with Plan B, just in case the forecast doesn’t pan out. “This playbook allows the company to have a mitigation plan in place in case its forecast proves to be off,” this FP&A practitioner explained. The company looks at what would happen if sales were up or down 10 percent, and then comes up with an action plan as to how it would handle the situation. “The focus is more

on downside risk. It’s one thing to review risk. But with-out translating that view into an action plan, it’s really not a very practical exercise.”

The playbook is a “qualitative action-based plan,” he explained. “We don’t run specific models or Monte Carlo simulations.” The way risk plays into the equa-tion is through conversations with senior management, specifically about top line performance. “That’s the trigger point,” he said. Part of the discussion is competi-tive analysis: looking at the company’s competitors along with their forecasts and past performance. That can highlight additional risk to the plan.

His advice to other companies looking to incorporate risk into their forecasting and planning process — be it quantitative or qualitative — is to try and take the 80/20 rule and focus on the 80 percent factors/risks that could affect the forecast and improve the assumptions on those levers, “as opposed to looking at smaller, immaterial im-pact levers. We tend to focus on the five or 10 risks that really impact our business and make us significant.”

Case Study 6: Insurance CompanyThis insurance company looks at external and internal risk factors to adjust its forecasting and business planning process. Those risks are fully integrated into the forecasting process.

>This student loan insurance company begins its risk management and forecasting process by looking at the pricing trends of student loans among banks. “We look at trends at defaulting loans as well,” said the CFO, “to make sure our assumptions are linked to these external trends. That’s the first line of incorporating market risk into the forecasting process.”

Financial planning models premiums and losses. “It’s fully integrated into the forecasting process. The modeling produces a probabilistic profitability/return outlook. Our leadership is constantly scanning for news that may impact our industry, be it positive or negative,” the CFO said. “The idea is to look at what factors may cause an expansion or contraction in sales and signs of competition — both of which would impact our ability to deliver on the plan.”

Another key risk the company monitors is regulatory risk. “We have a full-time person dedicated to that,” said

the CFO. “We’re also tuned-in to any potential changes in monetary policy that would affect interest rates, im-pacting us and our customers.”

He continued, “All of those risks are put into play as to how we believe we’re going to grow. The planning process doesn’t get done in isolation. At the end of the day we need to know: How realistic is our plan? We’ll run scenarios analysis where loss ratios go up or down, looking at the upside and downside of risk during the planning process.”

Risk forces the company to constantly update its outlook, the CFO said. “Three years ago, our forecast-ing models were very high-level and simplified,” he said. “As we started to understand our risks, the approach has become more granular so we can anticipate and analyze our risks using multiple scenarios of what could happen. You have to use enough variables to be able to under-stand how risk can affect business performance.”



As part of its monthly rolling forecasting process and an-nual plan, the company has an integrated planning and forecasting process, which includes supply chain, sales and macroeconomic risk analysis, according to its head of finance. “When we forecast, we run the whole process all the time with new information, and based on that information, we agree on our needs from our suppliers,” said the finance chief. The monthly forecast includes CapEx, OpEx and the financial aspects of the organiza-tion, i.e., the P&L and balance sheet.

With daily information about sales flowing in, the company has plenty of data and uses SAP to keep all parts of the organization on the same page. “In our company, we’re not working in silos and functions,” the CFO said. “The way finance is organized, we’re very much working together with ERM and the business with functions. We talk to marketing, supply chain, and financial planning to come up with an integrated view and multiple scenario analyses. We believe this integrated approach has im-proved the accuracy of our plan. We are all dependent on each other. We come together and agree on the risks that may affect the variability of performance. That’s happen-ing every period of every month.”

To assess risk, the company runs multiple scenarios each quarter and then decides what the most probable or likely forecast is. “We assess that number globally before we decide on our supply commitment. We have the

right to adjust the plan because they go into the finances monthly to decide on the forecast for the month and the next four quarters,” she said.

Macroeconomics are also taken into account, particu-larly during the annual planning cycle. But macro events are monitored continuously, according to this financial expert. For example, how the turmoil in the Ukraine affects their business was one of the issues the company was looking at as part of its ongoing process.

In addition, the company performs competitive analysis and collects intelligence in order to understand its competitive advantage. “The finance organization follows what is happening with our competitors, e.g., their new products coming into the market and expectations of price competition,” she said. “After all, we are in the consumer business. So factors such as aggressive pricing require ad-justments to the forecast and possibly the plan. Using this analysis, the company comes up with contingency plans. Analysis is not useful unless it leads to action.”

The company has an ERM program that’s run globally at the corporate level. That process is also integrated into the forecasting and planning approach. “When we create the annual plan, we take all those key risks and incorpo-rate them into the final plan,” she said. In addition, “as part of the normal management process, we look at how those risks are evolving, increasing or decreasing, and what new risks may be on the rise.”

Case Study 7: Consumer Electronics Manufacturer This consumer electronics maker takes micro- and macro economics into account when creating its production forecast and business performance outlook. The next step is integrating the process with ERM.

>



“The integration of risk and FP&A is still a work in progress,” said the CFO. “In my current role, my focus is on getting the buy-in of the leadership team. The best process of identifying risk is to work in a collaborative setting. It should be driven and managed by finance and should involve people from across the business. For this relatively small company, this means a big cultural change. Operators have not thought in those terms before.”

One of the new steps they have taken is to begin to carve out a section on risk during the strategy development session “when we have all the business unit leaders together,” he said. “We do a SWOT analysis, looking at internal and external factors to our business. I found that approach is very helpful as a starting point.”

SWOT helps categorize the internal weaknesses and

potential external threats that could be harmful to the orga-nization. The weakness need not be operational; it could be a lack of appropriate leadership. And a threat can be new legislation or macroeconomic matters. “By going through the process, you’re brainstorming with the leadership and getting different perspectives in addition to the primary business unit perspective,” he said.

With a former employer, this CFO previously worked on a process that included a 3/3 risk matrix that identified and quantified the impact certain risks may have on the plan, and tried to assign a dollar figure to that impact. “You want to spend a lot of time on risk,” he said, “high probability and high impact risks in particular, and use the probabil-ity analysis to come up with an action plan to reduce the severity and likelihood of the impact.” That’s where a lot of companies fall short, according to this veteran CFO, “i.e., in creating the playbook to address risk.”

Case Study 8: Small Energy Company To incorporate risk into forecasting, the company does a “threat assessment,” based on internal and external factors, during its management strategy sessions.

>

Conclusion“At its most developed level, risk-adjusted forecasting ‘shocks’ cash flow and earnings by introducing major risk factors to these drivers, and then generating a cor-responding probability distribution for each reporting period,” said Alsdorf.

Sometimes the models can be simple. “You can build it in a spreadsheet and use Monte Carlo simulations to look at individual risks, as well as risk combinations and their impact on the forecast,” said Bryn. “You set up the risks and the relationship between them, and then identify at what level of the financial statement they would have an impact.”

However, more advanced technology is now becom-ing available in many ERP systems to allow companies to incorporate firm-wide processes when running the analysis. “It makes life more complex but significantly more insightful,” she said.

The problem with using quantitative tools to try and adjust for risks is that it may lull companies into a false sense of complacency, according to Player. “It comes from the assumption that you can predict the future,” he said. And that’s an assumption he fundamentally challenged. That said, “there’s a huge role to understanding risk and risk in the world,” he acknowledged. “The best companies approach it not necessarily by ‘risk-adjusting’ their model. Many risks are external to the organization and are hard to quantify. What works is for the risk management func-tion to identify those risks and how the company can take advantage of the upside, or protect the organization from the downside. You need to take those elements and include them in the planning process.”

However, as the case studies demonstrated, companies don’t necessarily need fancy models to begin to work risk factors into their forecasting process. Player actually prefers



this more qualitative approach to risk adjustment with a focus on translating the outcomes into action plans. “This is a very qualitative process that’s needs to be ac-tion oriented,” Player said.

“The goal is to have a playbook on how to counter several things that would prevent the company from delivering on its plans, and look at multiple events hap-pening simultaneously. To be future-ready you have to have alternative plans,” he said. “Then look at the prob-ability and cost of executing those alternative plans.”

Companies need to constantly update that analysis. While tools like Monte Carlo simulations are great, they presume that you can measure the risks. “In many cases, companies face many risks without the real ability to quantify them,” said Player.

As ERM matures, companies will begin to integrate their risk management process more formally into their FP&A process. Some companies have already begun to break down the traditional silos. This is where FP&A can add the most value: in championing the process of bringing risk into the dialogue and incorporating multiple variables into its forecasting process using at least sce-nario analysis to prepare for a range of outcomes. Those forecasts can then help inform management decisions and improve the performance of the organization.

Risk-Adjustment Forecasting Best Practice Checklist• Starting small and building up capabilities

over time can sometimes help create buy-in from senior management because

incremental benefits can be demonstrated.

• Get management buy-in by showing early wins.

• Select only a small set of risks at first and integrate them into the normal course

of FP&A.

• Using a specific transaction to test this can make the paybacks clearer because they are more immediate and tend to get the attention of everyone in the company

(e.g., large CapEx investment, acquisition or divestiture).

• Incorporate multiple risks into the forecasting process and look at the interaction among those risks, since risk

rarely happens in isolation.

• Create scenario analyses to come up with different risk and opportunity outlooks based on a list of key risks facing

the organization.

• Use a qualitative approach when modeling is difficult or not available.

• Run a pre-mortem analysis to help create contingency plans.

• Integrate risk management and FP&A.

• Plan on a long-term implementation; this is

not an overnight transformation.

About the Author

Nilly Essaides is Director of Practitioner Content Development at the Association for Financial Professionals. Nilly has over 20 years of experience in research, writing and meeting facilitation in the global treasury arena. She is a thought leader and the author of multiple in-depth AFP Guides on treasury topics as well as monthly articles in AFP Exchange, the AFP’s flagship publication. Nilly was managing director at the NeuGroup and co-led the company’s successful peer group business. Nilly also co-authored a book about knowledge management and how to transfer best practices with the American Productivity and Quality Center (APQC).

About the Association for Financial Professionals

Headquartered outside Washington, D.C., the Association for Financial Professionals (AFP) is the professional society that represents finance executives globally. AFP established and administers the Certified Treasury ProfessionalTM and Certified Corporate FP&A ProfessionalTM credentials, which set standards of excellence in finance. The quarterly AFP Corporate Cash IndicatorsTM serve as a bellwether of economic growth. The AFP Annual Conference is the largest networking event for corporate finance professionals in the world. AFP, Association for Financial Professionals, Certified Treasury Professional, and Certified Corporate Financial Planning & Analysis Professional are registered trademarks of the Association for Financial Professionals.© 2014 Association for Financial Professionals, Inc.

All Rights Reserved.

General Inquiries [email protected]

Web Site www.AFPonline.org

Phone 301.907.2862

Visit workiva.com to see more.

Wdesk improves the quality andconsistency of data and analysis through:

• Collaboration and communication

• Integration of internal processes

• Development of shared data sets

Spend more time on analysis, and achieve operational and strategic objectives.

demystifying risk-adjusted forecastingforecasting and how teams can begin to transform their finance...

Documents