Forecasting and planning in a rebalancing world - EY · PDF fileForecasting and planning in a...

Forecasting and planning in a rebalancing worldBusiness Resilience

Forecasting and planning in a rebalancing world

Contents1 Forecasting and planning in a rebalancing world

2 This time it’s different

3 Isyourforecastingfitforpurpose?

4 Related reading

5 Contacts

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EY has been tracking profit warning data since 1999, giving us a unique insight into the fortunes of UK companies. The world economy has been transforming since the financial crisis, reshaping the economic landscape, making it harder and harder for companies to read and adapt to resultant changes in their markets. The failure to build accurate forecasts and absorb these blows contributed to UK profit warnings hitting a six-year high in 2014 — a level more consistent with a period of economic shock than recovery.

For many UK companies, the pressures of the last year represent a new reality, rather than a passing phase. As the world economy rebalances, long-held assumptions such as the increasing importance of emerging markets and the ability to raise prices are open to question. There are clear advantages for businesses that can take the initiative and demonstrate the market understanding and resilience necessary to match the vagaries of this recovery. The benefits from more accurate forecasts for companies are significant, from improved shareholder communications to more effective planning and decision-making. To achieve this, companies need to ensure that their forecasting and planning capabilities are current, fit for purpose, and able to adjust to more volatile times.


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This time it’s differentThe recent spike in UK profit warnings isn’t what we’d expect at this point in the recovery. In 2014, profit warnings reached their highest level since 2008, with a higher percentage of companies

warning in the final quarter than at any point during the last recession. The chart below shows how profound global shocks — such as the dot-com crash, the 2001 September 11 attacks and

the credit crisis — have corresponded to previous peaks. Rapid increases in energy and raw materials also can also push warnings higher, as they did in 2005.

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UK

GDP

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% of

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% of UK companies warning (inverted) UK GDP growth (%)

UK profit warnings out of sync with UK GDP growth

UK profit warnings and GDP growth

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This cycle looks different. Profit warnings fell in 2010 as growth returned and market expectations reset. However in 2011, more companies began to miss forecasts. In fact, corporate forecasts overreached for the next three years rising at the start of the year, but dropping by the end.

By 2014, the contrast between economic outlook and profit warnings looked especially stark. Whilst profit warnings reached a six-year high, a more entrenched UK recovery helped GDP to grow at its fastest rate since 2007, with expectations for more of the same in 2015. Global growth rates remained below par, but global GDP still grew faster in 2014 than 2013 — again with expectations of a better 2015.

Over confident or complacent? Data from our Capital Confidence Barometer survey also highlights the divergence between expectation and reality in 2014. In October 2014, 86% of UK respondents indicated positive expectations of global earnings growth and 93% expressed confidence in UK earnings — just before UK profit warnings reached their exceptional peak in the final quarter.

Obviously, 2014 ended in uncertainty and volatility due to the rapid fall in oil price and geopolitical tensions. However, the long standing nature of these forecasting misses suggests deeper problems that market volatility will only exacerbate.

EY’s latest UK Capital Confidence Barometer from April 2015, shows UK respondents have an exceptionally high level of global earnings confidence, but falling confidence in UK earnings expectations in the next 12 months. The disparity highlights how companies have struggled to forecast and benefit from the economic upturn due to unpredictable markets, strong sterling and unrelenting price pressures.

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2014 2013 2012 2011 2010 2009 2008

UK companies have struggled to forecast in this recoveryPercentage of companies warning

16.4% 14.9% 15.5% 13.9% 9.8% 13.8% 17.7%

It’s certainly a tougher economy to read. However, stakeholders, particularly investors, react badly to surprises. It suggests a lack of planning and control of business performance, even in unpredictable and volatile markets. Listed

companies in particular are under pressure to produce accurate forecasts and insight into their markets. The median share price fall on the day of profit warning rose to 11.6% in 2014, up by 2% from 2013.

Stakeholders of all businesses will be increasingly looking for businesses to show resilience in their ability to forecast and plan accordingly in order to absorb shocks. Forecasts matter.

April–2015 April–2015April–2014 April–2014October–2014 October–2014

EY Capital Confidence Barometer: UK respondents giving positive views on earnings

99%

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90%

13%

86%

70%

61%

45%

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61%

56%

Corporate earnings

Short-term marketstability

Credit availability

Equity valuations/stockmarket outlook

Global level Local level

84%

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37%

35%

90%

93%

68%

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Short-termmarket stability

Corporate earnings

Equity valuations/stock market outlook

Credit availability

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Is your forecasting fit for purpose?We’d contend that many of the forces that are making it harder for companies to forecast accurately represent new realities, rather than a passing phase. An improving macro outlook is no longer a guarantee of a smoother ride for UK companies. This is a clear reason to review established forecasting and planning processes. All too often these processes lack agility, are time-consuming, and fail to deliver any real insight. They almost become an end in themselves — something to ‘get out of the way’ before getting on with running the business.

Plans and forecasts are by their nature uncertain. Short-term forecasts are typically more accurate than long-term plans; but they are predictions about uncertain future events none-the-less.

Planning and forecasting systems are often overly complex and lack flexibility, but simple spreadsheet forecasting models have inherent risks and limitations too. The important point is to carefully consider why you need the forecast or plan, challenge both implicit and explicit assumptions regularly, and determine how and when the forecast should be updated. Most importantly, planning should be agile, current, responsive, and require a proportionate amount of time and effort for the value and insight delivered. Complexity, which often manifests itself in spurious levels of accuracy and detail, is the enemy of agility. Ultimately your plan is, or should be, your best view of the future.

Keep currentFew organisations have the capacity to anticipate major shocks in their market, but an out-of-date plan, which doesn’t reflect the current reality, is of little value. The world has moved on and so should the forecast, since actions that made sense yesterday may no longer offer the best course of action today. In such circumstances agile planning requires rapid re-evaluation of assumptions and a short reforecasting cycle to rapidly respond with mitigating actions.

New realities

Pricing and Competition

Potential for shocks

Currency volatility

New models

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Low levels of insolvency have left sectors with overcapacity, generating intense competition and pushing pricing pressures along the supply chain. ‘Disruptive’ new entrants and a technological revolution have added to the competitive tension.

With low inflation and even deflation, companies cannot put up their prices.

The accumulated pressure to invest, and yet cut costs and prices, led to price and competition issues featuring in 21% of profit warnings in 2014 — the highest we’ve recorded in 16 years.

Geopolitical, policy and price uncertainties make this an unpredictable recovery. So much so that the IMF and World Bank have trimmed growth forecasts again in 2015. Oil prices are the other great unknown of 2015, with unpredictable forces at play.

In Q4 2014, 27% of UK profit warnings cited contract delays or cancellations issues — the highest level since 2008 and a clear indicator of growing corporate concerns. Recent events show that what might be a key growth region in January could be a strategic exit by June.

Diverging monetary policies, uncertainty over the timing of US tightening and emerging market vulnerabilities will continue to drive currency volatility in 2015 — and beyond. The strong pound was a particular issue in 2014. Even a neutral stance by the Bank of England will contrast sharply with loosening across most of Europe and Asia in 2015.

UK companies cited exchange rates in 17% of profit warnings in 2014 — the highest we’ve recorded in 16 years and well above the average of 3%.

It’s clear that historical trends and relationships are a poor guide to the future. There’s a new economic pecking order beyond BRICS, MIST or MINT. New economic, business and behavioural models are required to predict demand. Technological changes have altered the way we live, work and shop.

Companies that are unable to flex and adapt their business models, cost base and strategies will find little margin for error.

Pressure from both sides

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Forecasts, and the activity of forecasting, are only useful if:

► They offer insights and inform important decisions

► They communicate plans in a way to drive behaviour

► They can be used to monitor financial performance, position and cash flow — driving corrective actions and reducing risk

► They are used to guide market expectations and minimise surprises

Corporate Strategy

Business Objectives

Organisational Design

Operations

Embed uncertainty

Forecasting model

Rapid reforecasting cycle

Agile, risk-based forecasting — illustrative example

Define key driversMore insightful, ris

k-based

analysis

Financing

Tax

Integrated financial

forecasting

KPIs

ValueDet

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Financing

Tax

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M&A

Risk-based scenarios

Sensitivity Analysis

Impact on value

Capital requirements

Headroom and debt covenants

Monte Carlo simulation

Econometric modeling

Data analytics

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Recognise and embrace uncertaintyForecasts should acknowledge and reflect the uncertainty in the underlying assumptions on which the forecast is based. Assumptions should be revisited regularly and stress-tested through simple sensitivity and scenario analysis. Where attempts can be made to quantify the degree of uncertainty in key assumptions, or rich historical data sets exist, then other advanced forecasting techniques can be employed (e.g., Monte Carlo analysis, options analysis, predictive analytics, econometric forecasting). This can significantly enhance your existing analysis and offer a much deeper appreciation of the future.

Such techniques are particularly effective when short-term business performance is at the mercy of uncontrollable or volatile external factors such as commodity prices,

foreign exchange and interest rates or where major contract slippage or project costs could derail forecast results.

Economic and political risk is going to remain a feature of the environment facing businesses. Political risk continues to increase in significance. UK respondents to EY’s Capital Confidence Barometer have currency and commodity prices firmly on their agenda.

Create risk-based scenariosConsider the impact of known risks by ‘stress testing’ the forecast. Your forecast should have sufficient flexibility to run a series of risk-based scenarios and consider the impact on financial performance, liquidity and solvency. This is particularly important to clearly demonstrate how financial performance may be affected by identified risk scenarios, and how the business would respond with mitigating actions.

Risk of external shocks focuses attention on scenario-based analysisBy any standard, the outlook for 2015 is highly unpredictable.

► Eurozone: outlook remains clouded by the uncertain fate of Greece

► Oil: price crash has exposed corporate and sovereign weaknesses

► Russia: weakened by sanctions, highly unpredictable

► Federal reserve: risk of further currency and market volatility linked to comments and actions — especially for emerging markets

► UK general election: Risk of contract hiatus and referendums, under some scenarios.

Stakeholders are increasingly looking for evidence that companies have built forecasting and planning approaches that allow for scenario analysis. It’s not possible to avoid shocks, but careful up-front analysis will at least build an understanding and allow companies to have contingency operational and communication plans in place. This will provide the opportunity to mitigate adverse impacts on both results and market sentiment.

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Increased global and regionalpolitical instability

Increased volatility incommodities and currencies

Economic situation in theEurozone

Regulatory environment

Slowing growth in key emergingmarkets

Deflation Apr–15

EY Capital Confidence Barometer: UK respondents identify greatest economic risks to their business in next 6–12 months

Be careful out there

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Taking account of the company’s current position and principal risks, explain how they have assessed the prospects of the company, over what period* they have done so and why they consider that period *to be appropriate.

State whether they have a reasonable expectation that the company will be able to continue in operation and meet its liabilities as they fall due over the period* of their assessment, drawing attention to any qualifications or assumptions as necessary.

*Expected to be significantly longer than 12 months from signing date other than in rare circumstances

New statement in addition to the current going concern statement (which is still to be provided on an accounting basis)

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The viability statementFinancial reporting council changes throws further spotlight onto forecasts

Changes required under the FRC Corporate Governance code create a further regulatory need for resilient forecasting and planning processes. The code applies to all companies with a premium listing of equity shares on the London Stock

Exchange, regardless of whether they are incorporated in the UK or elsewhere. The requirements include:

A robust risk assessment and mitigation of principal risks that would threaten the entity’s business model, future performance, solvency or liquidity. The directors should describe those risks and explain how they are being managed or mitigated.

New, longer-term viability statement in the annual report. Directors have to explain in the annual report (taking account of the company’s current position and principal risks) how they have assessed the prospects of the company, over what period and why they consider that period to be appropriate.

Validating assessment

Assessment considerations & requirements

Period covered

Depth of assumptions and scenarios

Assessing key risk combinations

Business strategy

Risk registerIncluding principal

risks

Financial forecasts

Culture and risk culture

Qualitative and quantitative assessment

Sensitivity analysis

Severe downside scenarios

Reverse stress testing

What’s new/different?Standard good practice

Risk appetite and quantifications

BusinessResilience

The guidance changes have raised the standard but this can be an opportunity to add value. It is a chance for companies to better understand their risks and their risk appetite.

Adapt

Identify Miti

gate

Stakeholder

resilience

Capital

resilience

Market resilience

Operational

resilience

Business resilience

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Profit Warnings

www.ey.com/UK/profitwarnings

Our quarterly analysis of UK Profit Warnings, issued by quoted companies, provides an insight

into profit warning trends and the key economic, sector and market issues facing all businesses.

Global Capital Confidence Barometer

www.ey.com/ccb

The survey led by the EIU gauges corporate confidence in the economic outlook and identifies boardroom trends and practices in the way

companies manage their Capital Agendas.

Viability Statement

www.ey.com/UK/en/Issues/EY-the-viability-statement

The viability statement: Finding opportunities in the new regulatory challenge

Business Resilience

www.ey.com/UK/businessresilience

Cash isn’t everything … It’s the only thing

Analysis of profit warningsIssued by UK quoted companies

Q4 2014

Profit warnings surge again as uncertainties buildProfit warnings reached their highest fourth quarter total since 2008 in Q4 2014, with 93 warnings also taking the annual total for 2014 to a six-year high.

It’s a level of profit warnings more consistent with a period of low growth or global shock than an improving macro outlook. Undoubtedly, many companies have faced increasing challenges to their forecasts in recent months from rising geopolitical concerns and falling oil prices. The uncertainties that lie ahead in 2015 have also interrupted contract cycles, whilst pricing pressures continue to reverberate along supply chains. The shape of this recovery, in particular low levels of insolvency, has also created overcapacity, leading to intense competition. Disruptive technologies and businesses continue to reshape sectors. All-in-all, there is often little room for error.

However, many of these pressures represent new realities, rather than a passing phase. An improving macro outlook is no longer a guarantee of a smoother ride for UK plc. To avoid being at the mercy of events — and to improve investor communications — companies need to take the initiative, build operational and capital resilience and adapt their forecasting and planning capabilities to the dynamics of the post-crisis economy.

Profit warning numbers, Q1 2007–Q4 2014

2014

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2007 total:384

2008 total:449

2009 total:282

2010 total:196

2011 total:278

2012 total:287

2013 total:255

2014 total:299

2009: 282

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An improving macro outlook is no longer a guarantee of a smoother ride for UK plc.

Contacts

Alan Hudson Partner +44 20 7951 9947 [email protected]

Lee Watson Partner +44 20 7951 3274 [email protected]

Jon Morris Partner +44 20 7951 9869 [email protected]

Kirsten Tompkins Analyst +44 121 535 2504 [email protected]

October 2014 | ey.com/ccb | 11th edition

CapitalConfidenceBarometer

Global

Middle-market deals to fuel M&A rebound

CCB_global_final_241014.indd 2 24/10/2014 08:40:01

The viability statementFinding opportunities in the new regulatory challengeMarch 2015

Business ResilienceActively adapting to preserve value

Cash isn’t everything …It’s the only thingCash flow forecasting: enabling your stakeholder and capital resilience

Related reading

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How we can helpEffective financial planning and forecasting can be a source of competitive advantage through the formation of timely insights, establishment of corrective actions and anticipation of future events.

EY’s Valuation, Business Modelling & Economic Advisory team has extensive experience in developing planning and forecasting models to deliver insightful, timely analysis. We can help streamline your planning processes, shorten reforecasting cycles, and improve the quality of forecasts through careful design and consideration of business needs. With the use of sophisticated analytical tools and techniques we recognise and quantify uncertainty and volatility in your underlying assumptions resulting in more insightful analysis and better decisions.

Jon MorrisPartner, Restructuring

T: + 44 20 7951 9869E: [email protected]

Contacts

For related enquiries contact

E: [email protected]

Natalia PugachDirector, Valuation & Business Modelling

T: + 44 20 7951 9620 E: [email protected]

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