Kevin L. Boyle, Consulting

Stress testing is an exercise normally associated with banks.  However, since the recession of 2008-2009, other companies have been performing stress tests on their financial statements.  Dow Chemical, for example, states in the notes to their financial statements that they have stress tested their results.  Neither Dow nor any other company, except for banks, usually make the results of the stress tests public, nor do they elaborate on changes to their planning or operations undertaken as a result of the stress test.

Stress testing is not simply constructing a worst case scenario.  By definition, stress testing creates a scenario involving a possible, but not probable macroeconomic shock.  The effects of this shock are then translated into affects on variables relevant to company performance.  The new value of these key variables is then introduced into financial statements to observe the condition of the operation as a reaction to the macroeconomic shock.  For banks, the variables are very well defined, but for commercial and industrial operations, the affected variables are up to the company to identify and gauge properly.

The value of stress testing for companies is clear.  If a company can foresee what their P&L will look like in the event of some macroeconomic shock ahead of the occurrence, they have the luxury of adjusting their current financial and market position to weather that shock while continuing to pursue promising investments under normal conditions.  Advantageously positioning long term debt, building short term financing facilities, adjusting product lines, refining geographic presence, structuring supply chains, and establishing contingency plans to deflect risk and take advantage of opportunities are all potential consequences of stress testing.

Scenario Testing is similar to stress testing.  In the case of scenario testing, the company has identified risks to their annual plan, usually during the construction of their “worst case.”  These risks are normally more focused and may include lower revenues, higher interest rates, or investments that produce subpar returns.  But the extrapolation of the worst case rarely moves to the P&L or to other areas of the business that would likely be affected.  In other words, the measured effects of the worst case scenario are incomplete.

Stress Testing

Stress testing involves the development of a macroeconomic stress beyond the control of the company—oil at $200 per barrel for example.  The process for an individual company involves:

• Development of a macroeconomic scenario that is possible, but not probable,
• A statistical determination of the effects of the macroeconomic stress on the company’s business,
• A bottom-up translation of the stress scenario into tangible affects on the company,
• A determination of the behavioral characteristics of the line items affected,
• Running simulations to determine the possible inputs to the company’s financial and operational results,
• The formulation of reactions and strategic/contingency plans to counter the effects of the stress scenario,
• The development of metrics to “foretell” the impending actualization of stress scenarios

Scenario Testing

Scenario testing follows a similar course except that the risks are probable often with a quantifiable probability of occurring.  Scenario testing can also be applied on a smaller scale to annual plans, projects and investments, and even product lines.  On a large scale, the results of scenario testing may be pro forma P&Ls.  A more focused approach yields risk mitigation measures that are immediately actionable.

Why Engage Kevin L. Boyle, Consulting?

Kevin L. Boyle, Consulting, has developed an expertise in applying Stress Testing and Scenario Testing, drawing from many different sources.  Experience garnered at the highest academic level of applying bank stress testing techniques to commercial enterprises.  Practical scenario testing experience from decades of leading new business development efforts, acquisitions, and project management.

Kevin L. Boyle, Consulting, has carefully constructed macroeconomic scenarios both possible, for stress testing, and probable for scenario testing.  Given the uncertainty in the near future environment, now is the time to stress test your P&L, or scenario test your annual plan or project.