The benefits of reverse stress testing in reviewing financial forecasts
All directors have obligations with respect to going concern considerations, and these considerations have been significantly impacted by the COVID-19 pandemic.
It is certainly a challenging time to be forecasting financial outcomes for many businesses. The use of reverse stress testing by management and directors to appraise their going concern assessment offers a new perspective.
Stress testing of financial forecasts in the traditional sense would involve the consideration of a variety of values for the key assumptions embedded within those forecasts, and determining the possible impacts of those variables.
Reverse stress testing starts with a defined outcome, such as breaching banking covenants or business failure being examples, before considering what scenarios and key assumptions could result in that outcome. Failure can occur well before the point at which liquidity is exhausted, and the reverse stress testing can help identify those early issues that lead to failure.
As Auditors we have been using reverse stress testing to challenge and appraise the forecasts prepared by management as part of the going concern consideration at the close of an audit.
Our focus tends to be on when an entity might run out of cash, when banking covenants might be breached or when debt is due to be repaid. We consider a range of adverse circumstances that would cause these outcomes and then discuss the probabilities of these circumstances occurring.
Reverse stress testing can also be used by management to identify areas of risk and weakness through their financial forecasts, which can then in turn be used to develop strategies to mitigate these risk occurring.
This might for example give a business an opportunity to commence early discussions with finance providers to seek waivers of covenants where they are forecasting future breaches, giving management more time to react to events and consider changes in the business strategy.