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No Safe Harbour for Finance in the Storm that is 2024




A year ago, I wrote how finance professionals could face challenges of forecasting in a world characterised by global supply chain disruptions, war in Ukraine, and surging inflation. Well if you thought 2023 was challenging, 2024 shows no signs of being any easier. Many of the same challenges remain — and new ones are emerging: near total war in the Middle East, election chaos in the U.S., stubborn inflation pressures, even the weather is getting in on the act as fires, floods, and earthquakes abound. Only the stock market seems unaffected but how long can that last?


Globally, emboldened workers are seeking to leverage relatively low unemployment rates in most major economies to secure substantial wage rises, leading to significant increases in labour costs. In the US, the United Auto Workers union launched strikes against all three Detroit automakers and secured 25% pay increases spread over four and a half years. Meanwhile, in the UK this year, employees' average annual total pay increased 8.5% between June and August. In addition, war in the Middle East — and upcoming elections in the US — have further clouded the picture.


Even in China, long the country of choice for low-cost manufacturing, labour costs have been rising rapidly, which, when combined with a desire for shorter and simpler supply chains and increasing political uncertainty, is leading companies to redirect foreign investment. Bloomberg reported in November 2023 that a measure of direct investment into China turned negative for the first time since records began in 1998.


Economic forecasts for 2024 are divided between dire predictions of a significant economic downturn and continued global growth, albeit slowing slightly next year to 2.9%, according to the International Monetary Fund.


So how should finance professionals address the challenges of an uncertain future? The foundation is solid core for planning and decision-making focused on four areas:

  1. Concentrate on what we can control;

  2. Maintaining agility and flexibility;

  3. Strategically controlling expenses;

  4. Cautiously managing cash and capital.

Concentrate on what we can control

The macroeconomic environment is beyond our control. We must be prepared for the world we are given and focus on what we can control. At its simplest, this means answering two questions: What products and services are we going to sell? How are we going to price them?


Every other decision is a function of how we answer these two questions. Which markets are we going to participate in? How are we going to go to market? What resources do we need? What capabilities do we need? How much investment is required? And so on.


Over the last two years, we have experienced an unusual set of circumstances: rising interest rates, high inflation, and near full employment. This has allowed many organisations to exert pricing power in the market without materially impacting demand. However, there are signs of stress emerging. UK unemployment rates are ticking up and US consumer spending growth has slowed. The positive news is that inflation rates are slowly falling, signalling that companies are unlikely to be able to continue passing increased costs onto customers in 2024. As finance professionals, we need to help our organisations navigate the changing environment by deploying tools that explicitly address variability in the macro environment. 

The convergence of global economic (inflation, interest rates), political (Middle East, Ukraine, China, US presidential election), and social (work from home, ageing populations) drivers makes it very difficult to forecast confidently. We should accept that and adapt our approaches accordingly.


For example, scenario planning allows finance professionals to model alternate strategies and resource allocations under different sets of macroeconomic assumptions. A European-based manufacturing company is using scenario planning to determine the optimal balance between in-house manufacturing and contract manufacturing under a range of different economic scenarios. Although contract manufacturing for small batches incurs higher variable costs, it also reduces the risk of carrying excess capacity and its associated fixed costs if demand falls. By providing clear guidance on the optimal mix at different demand levels, the company can improve profitability across a broad range of economic conditions.

Combining well-designed scenario plans with contingency plans that set out actions to address low-probability but high-materiality events can reduce the negative impact of economic volatility.


Maintain agility and flexibility

There has been a slow migration over the past 20 years from calendar-driven, backward-looking financial management and planning processes such as annual budgeting, variance analysis, and period-end reporting to more dynamic, forward-looking processes such as exception-based reporting, scenario modelling, and predictive forecasting.  

 

The current environment provides a compelling reason to take these capabilities to the next level. With advances in digitisation, data science, and artificial intelligence, finance can create richer and more prescriptive analyses much more rapidly. Today, leading companies develop an updated forecast in hours rather than days, have near-continuous visibility of changes in their cash positions, and respond to requests for ad hoc analysis in real time. 

While there is hype around AI, its potential is real. A recent McKinsey report that estimated generative AI could add up to $4.4 trillion of value annually across the 63 use cases examined, more than the GDP of the UK. Some of the specific ways AI is applicable to finance include generating future cash flow projections, optimising credit terms across the customer portfolio, generating more accurate statutory and tax reports with minimal manual effort, identifying and correcting data errors, and optimising audit and control processes.   

To be more flexible, finance must reduce the time spent on routine, repeatable tasks that could otherwise be automated or delegated. This would free up more time to predict, react, and respond to events happening in the market or business.


Focus on strategic control of costs

As pricing power diminishes, organisations will need to become more disciplined in developing improvements in productivity to offset increases in raw material, labour, and other costs. Historically, organisations have been weak at tying increased costs or investments to improvements in productivity. A simple test is to look at whether your organisation has a rigorous process for tracking the actual returns on investments against those projected in the original business case. Did that project with an attractive internal rate of return or net present value actually deliver the predicted returns?


High-performing organisations are becoming much more scientific in their approaches to expense management. Instead of arbitrary across-the-board budget cuts and spending caps, tools such as zero-based budgeting and dynamic expenditure management help tie expenses to the true drivers of business activity and align them to the realities of the current operating environment. These capabilities will become even more important if an economic slowdown starts to squeeze profit margins.


Cautiously manage cash and capital

A high interest rate environment is a double-edged sword. Borrowing costs rise but idle cash can generate useful income. Unfortunately, inflation reduces the value of that income. Many companies (like many homeowners) may have to refinance debt at a cost higher than they have seen for more than 20 years. Debt servicing will eat into cashflow alongside higher input and labour costs. Finance needs to look at a broad range of cash management options to navigate such an environment. The right mix of working capital optimisation, debt reduction, and expense management can increase management and operational flexibility. 


Ensuring that your organisation's cash accounting and forecasting processes are timely and accurate is essential. Unlike our accrual accounting processes, which have benefited from significant process and technology change, too often cash forecasting is still a manual process relying on spreadsheets and ad hoc data collection. In times of uncertainty, cash accounting is a better indicator of the immediate health and viability of a business than accrual accounting.


With respect to capital investment, the rising cost of capital increases the hurdle rate that should be used for evaluating capital investment decisions. We need to look at the alternative risk/return of three different types of capital investment: maintenance or replacement capital that sustains current business operations, such as replacing machinery and maintaining infrastructure; investments that improve productivity, such as adding new automation or digital capabilities, expanding product lines or entering new markets; and speculative investments that take the business into new areas such as research and development and business diversification.


In times of uncertainty, it is tempting to eliminate all but essential investment. That is rarely a successful strategy. Failure to invest in the future of the business all but guarantees that an organisation will fall behind competitors who have adopted a more balanced approach to investment.


Excelling at these four disciplines provides accounting and finance professionals with the tools to help their organisations navigate turbulent waters ahead with agility and confidence.


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