Why do certain companies respond faster and better than others to closures of shipping chokepoints, spikes in commodity prices, artificial intelligence (AI) breakthroughs, and other market opportunities and emerging threats that define this “decade of disruption?”
The answer boils down to the fact that some organizations have early-warning mechanisms in place that equip their C-suite executives and boards with the time advantage needed to anticipate and respond to market developments that upend implicit assumptions underpinning financial plans and corporate strategies. Simply stated, early movers who take advantage of emerging opportunities have more options when making decisions on how to respond. CFOs can play a lead role in building early-warning capabilities. Finance groups that don’t place their organizations at a distinct disadvantage in today’s transform or decline business environment.
The secret sauce is not difficult to replicate. Astute boards and C-suite leaders regularly identify and stress-test critical assumptions concerning the company’s underlying business model. These assumptions are often implicit, which can make them dangerous if they remain unexamined until it becomes obvious they are no longer valid. At that point, decision-making options are extremely limited as the organization becomes captive to events.
Forward-thinking CFOs can help overcome this disruption risk by shedding light on the soft spots inherent in strategic dashboards. This work consists of developing an early warning capability that continually monitors the underlying assumptions and fundamental drivers of the financial plan, using signals from lead metrics that enable proactive adjustments and course corrections as necessary. When these indicators flash red (or even yellow!), CFOs escalate their analysis to the C-suite and board, as it may foretell that underlying business fundamentals are on the cusp of transformative change.
Hard spots, soft spots and blind spots
The subprime mortgage meltdown crisis is a clear example of the value of being an early mover when market fundamentals change. What differentiated financial institutions that found a seat in the ring when the music stopped from those institutions left standing? In 2007, warning signals began rippling through housing and credit markets. At that time, many financial institutions adhered to the widely held view in the industry that a systemic, nationwide decline in U.S. home values was extremely unlikely, and perhaps impossible. After all, it hadn’t happened before and they were making a lot of money.
But a handful of financial institutions asked an important question: How much would it hurt us if there were a systemic nationwide decline in the U.S. housing market? And they didn’t like how that scenario played out. Accordingly, they responded quite differently to the market signals they identified—by shedding their exposure to mortgage‑backed securities (MBS), collateralized debt obligations (CDOs) and other toxic, subprime assets as quickly as they could. And they were able to do this because there remained an insatiable appetite for these securities by other institutions that continued to dance to the music. As the crisis played out, the forward-looking banks were positioned to scoop up distressed assets of failed institutions at rock-bottom prices during the industry shakeout after the music stopped.
An early-warning capability is an opportunity for CFOs. The finance group’s early warning capability encourages business leaders to identify shifts in the external environment timely enough to enable a response before those changes threaten the organization’s strategy or erode its competitive advantage. Which assumptions concerning customers, markets, competitors, technology, regulatory behavior, natural resources, geopolitics, supply chains and other external factors have the greatest impact on our ability to execute our strategy successfully? And what scenarios could invalidate one or more of our critical assumptions?
Addressing these questions helps C-suites and boards identify which factors have the greatest impacts on the success or failure of the business model. That’s the idea—in theory. When senior leaders are deeply enamored with a successful business model, they are particularly at risk of neglecting market shifts and other scenarios that can invalidate strategic assumptions underpinning their go-to-market approach. CFOs can help shed light on these blind spots by focusing a critical eye on the financial plan’s implicit assumptions.
Giving leaders the gift of time
Finance’s early warning capability requires a combination of assumption testing, scenario analysis, signal detection, reporting and response discipline. Building this capability involves:
- Identifying critical assumptions: Financial plans contain implicit assumptions regarding revenue drivers, operating costs, time horizons and other variables. These assumptions should be identified and documented, with emphasis on the revenue drivers and cost drivers that flow to the bottom line.
- Subjecting those assumptions to scenario analyses: These implicit assumptions should be stress-tested through scenario analyses. For example, the Iran conflict has affected assumptions concerning the stability of energy-related costs—the price of oil temporarily surged by more than 60% in response to the Strait of Hormuz blockage. Similarly, assumptions regarding the size and timing of the knock-on effects of spiking oil prices may need rethinking. Rising plastic-packaging and fertilizer costs may not be baked into current pricing. If so, how long will it take for prices to adjust? New freight surcharges and higher landed costs (e.g., duties, taxes and fees) must be reflected in cost structures and counteracted with revenue increases to prevent erosion in margins. The focus is on what can go wrong that would affect our key assumptions, the velocity at which these events—or combination of events—could unfold, and the estimated magnitude of the impact as well as opportunities associated with the event or development. What if a new entrant compresses margins in our highest-value segment by 25% within 12 months? What happens to our revenue model if a key technology platform shifts? What if a regulatory change simultaneously alters our cost structure in two major markets?
- Select the scenarios that truly matter: By modeling the financial implications of these types of scenarios, a CFO grounds risk discussions in hard numbers and facilitates the isolating of scenarios that matter most. As one chief risk officer once told me, the idea is to spot rattlesnakes on the trail the organization is traveling. He indicated that a rattlesnake might appear from time to time, but when the leadership team knows it’s there and how much its bite might hurt, they can assess whether to continue on that path or shift the organization’s direction.
- Monitoring forward-looking metrics: For the most important scenarios, the CFO works with other senior leaders to design the appropriate lead key risk indicators (KRIs) that would offer decision makers an early warning indicating the scenario of concern may be developing. For example, when these measures exceed predefined tolerance levels, they require escalation to the C-Suite and, if necessary, to the board. In determining key indicators, CFOs need to identify not only what external factors are important, but also how to access the external data sources that allow them to monitor market dynamics.
- Acting: Even the most prescient and discriminating early warning capabilities are of little value if finance and business leaders fail to act on their outputs. An organizational culture that emphasizes change readiness, resilience and a seize-the-moment mindset helps foster timely responses to early warnings. So, too, does a finance group with a reputation for delivering “better data sooner.” Data-driven financial insights based on a reliable, trusted and unbiased single version of the truth are difficult to refute and are highly motivational.
A final note: early warning capabilities are not fail-safe. It is almost inevitable that an organization will at some point fail to recognize or react to market signals in time. When this occurs, CFOs can initiate post-mortem reviews of what went wrong and leverage those hard-earned lessons to recalibrate assumptions, develop better metrics, or refine reporting and escalation protocols. This type of continuous improvement loop steadily fortifies the finance group’s early warning capability, which, in a decade defined by disruption, qualifies as a competitive advantage.
This article originally appeared on Forbes CFO Network.
