Be prepared for a bumpy ride

Imagine you’re nicely settled down in your airline seat on a transatlantic flight – comfort-able, with a great feeling. Then the captain comes on and welcomes everybody on board and continues, “It’s the first time I fly this type of machine, so wish me luck!” Still feeling great?¹

Running a company in today’s interconnected and volatile world has become extremely complicated; surely far more than flying an airliner. You probably don’t have all the indicators, dashboard system and controls as on a flight deck. And business conditions are likely to change for more than flight conditions ever will. Today we live with an information overload. Data streaming at us almost everywhere we turn. How can we cope? How do we make smart decisions?

Pilots train over and over again. They spend hour after hour in flight simulators before being allowed to sit as co-pilots on a real passenger flight. Fortunately, for us passengers, flight hours normally pass by, day after day, without much excitement. Time to hit the simulator again and train engine fires, damaged landing gear, landing on water, passenger evacuation etc. becoming both mentally and practically prepared to manage the worst.

Why aren’t we running business simulations to the same extent? Accounting, financial models and budgeting is more an art than science, many times founded on theories from the last century. (Not to mention Pacioli’s Italian accounting from 1491.) While the theory of behavioural economics progresses we must use the best tools we can get to better understand financial risks and opportunities and how to improve and refine value creation. The true job we’re set to do.

How is it done? Like Einstein – seeking simplicity, as far as it goes. Finding out which pieces of information that is most crucial to the success and survival of the business. For major corporations these can be drawn down from the hundreds to some twenty key variables. (These variables are not set in stone once and for all, but need to be redefined in accordance with the business situation we foresee in the near future.)

At Allevo our focal point is on Risk Governance at large and helping organisations implement Enterprise Risk Management (ERM) frame¬works and processes, specifically assisting boards and executive management to exercise their Risk Oversight duties. Fundamental to good risk management practice is to understand end articulate the organisation’s (i.e. the Board’s) appetite for risk. Without understanding the appetite and tolerance levels for various risks it’s hard to measure, aggregate and prioritize them. How much are we willing to spend on new ventures and opportunities? How much can we afford to lose? How do we calculate the trade-offs?

There are two essential elements of Risk Appetite: risk capacity and risk capability.

By risk capacity we mean the financial ability to take on new opportunities with their inherent risks (i.e. availability of cash and funding across the strategy period). By risk capability is meant the non-financial resources of the organisation. Do we have the know¬ledge and resources to take on new ventures? Cash and funding is fundamental and comes first.

Does executive management and the board really understand the strengths and vulnerabilities hiding in the balance sheet or in the P&L-account? Many may have a gut feeling, mostly the CFO and the treasury department. But shouldn’t the executive team and the board (including the Audit Committee, and the Risk Committee if there is one) also really know?

At Allevo we have aligned with Strategy@Risk Ltd to do business simulations. They have experiences from all kinds of industries; especially process industries where they even helped optimize manufacturing processes. They have simulated airports and flight patterns for a whole country. For companies with high level of raw material and commodity risks they simulate optimum hedging strategies. But their main contribution, in our opinion, is their ability to simulate your organisation’s balance sheet and P&L accounts. They have created a simulation tool that can be applied to a whole corporation. It needs only to be adjusted to your specific operations and business environ¬ments, which is done through inter-views and a few workshops with your own people that have the best knowledge of your business (operations, finances, markets, strategy etc.).

When the key variables have been identified, it’s time to run the first Monte Carlo simulations to find out if the model fits with recent actual experiences and otherwise feels reliable.

No model can ever predict the future. What we want to do is to find the key strengths and weaknesses in your operations and in your balance sheet. By running sensitivity analysis we can first of all understand which the key variables are. We want to focus what’s important, and leave alone those variables that have little effect on outcomes.

Now, it’s time for the most important part. Considering how the selected variables can vary and interact over time. The future contains an inconceivable amount of different outcomes²). What does that say about budgeting with discrete numbers?)). The question is how can we achieve the outcomes that we desire and avoid the ones that we dread the most?

Running 10,000 simulations (i.e. closing each and every annual account over 10,000 years) we can stop the simulation when reaching a desired level of outcome and investigate the position of the key variables. Likewise when nasty results appear, we stop again and recording the underlying position of each variable.

The simulations generate an 80-page standard report (which, once again, can feel like information overload). But once you’ve got a feeling for the sensitivity of the business you could instead do specific “what if?” analysis of scenarios of special interest to yourself, the executive team or to the board.

Finally, the model equates the probability distribution of the organisation’s Enterprise Value going forward. The key for any business is to grow Enterprise Value.

Simulations show how the likelihood of increasing or losing value varies with different strategies. This part of the simulation tool could be extremely important in strategy selection.

If you wish to go into more depth on how simulations can support you and your organisation, please visit

www.allevo.se or www.strategy-at-risk.com

There you’ll find a great depth of material to chose from; or call us direct and we’ll schedule a quick on-site presentation.

Have a good flight, and …

Happy landing!