As the year begins to wind down, many companies are putting the finishing touches on their financial and operations plans for 2012. Regardless of how far along you’ve gotten in your planning, you should consider adding a stress test if you haven’t done so already.
A financial stress test has much in common with the well-known cardiac stress test. In both cases, the goal is to determine how something—your heart or your business—will react under simulated strains while under the protection of a controlled environment. The process provides rich information as to the true health of the test subject such as underlying problems to be treated before they become acute crises. A stress test also helps determine where resources should be allocated to prevent future problems from occurring.
As Peter Drucker stated on numerous occasions, “The most serious mistakes are not being made as a result of wrong answers. The truly dangerous thing is asking the wrong questions." An effective stress test measures your company’s ability to respond to acute and plausible situations that may arise. The “acute” part is important because it implies that the effect could be significant and your company will have little time to prepare in advance. The plausible part is equally important to avoid wasting time on the infinite universe of possibilities that could affect your business. Stress testing for a potential alien invasion might not be the best use of your time.
When devising your scenarios, it’s important to consider using a matrix approach that combines potential stressors at global, national, industry and company-wide levels.
Some examples of realistic and acute scenarios that you should consider stress testing are:
- The Euro as a currency collapses, leading to a global disruption of financial markets, a significant increase in interest rates and a severe credit crunch as U.S. banks rigorously try to compensate for their exposure to European sovereign debt.
- China decides to suspend its purchase of U.S. Treasury securities, favoring instead domestic investment to prevent a severe recession.
- A flare-up in political tensions in the Middle East sends oil prices skyrocketing
- An inability to reach a consensus on appropriations due to political tensions leads to a major (but not complete) shut down in government services.
- As the budget deficit reaches unprecedented and unsustainable levels, corporate income tax marginal rates increase significantly.
- After another financial shock wreaks havoc among large banks, business credit completely freezes while a deadlocked Washington, D.C. fails to agree on a solution.
- In an effort to placate organizations and movements deemed anti-business, the Executive branch of government significantly expands regulations and slows down the permitting process for your industry.
- After failing to reach a consensus on a new collective bargaining agreement, your factory workers go on strike.
- A raw material used in the development of your product is found to contain hazardous materials and its use is banned by Federal regulators as a result.
- An unexpected earthquake in California destroys your main source of raw materials with no expectation of the company returning to operations in the near future.
- A routine audit discovers that several managers and employees colluded to defraud your company of $3 million while also falsifying financial statements that were subsequently used by investors to evaluate an investment in your company.
- After a new technology launches, your company is now forced to compete with a solution which offers customers the same results for one fifth the cost of your solution.
If your management team decides to pursue stress testing, consider the following proven best practices to ensure you achieve the best results.
- Record everything for internal training purposes. Similar to a case study, stress tests provide great learning opportunities for future managers and executives at your company. Make arrangements to record the documents, discussions and results of the stress test. Make them available as part of a formal management training process and as a resource on your company’s intranet.
- Include a cross-functional team. While some types of stress tests, like currency-fluctuations, fall mainly on the finance department, it’s important to have all key departments represented. This will help your company assess the impact of stressors in a richer and more realistic context.
- Give participants the freedom to work outside of your traditional structure. An acute stressor that isn’t properly anticipated can lead to the demise of your company in a short amount of time. When planning a response, you don’t want to have your employees worry about what will make them “look good” in a meeting. Consider holding your stress test planning offsite and make it clear to participants that this isn’t for a bonus, promotion or brownie points; egos will be checked at the door.