Financial planning is essential to any business’s survival. Companies need to understand how their sales, cash flow, profits, and more will look in the future. The biggest problem is that the future is uncertain. Anything is possible.
How can companies mitigate risks and foresee future financial trajectories and outlooks?
A base case evaluation uses the most likely set of assumptions about a given situation to arrive at the most likely outcome. Here, we’ll discuss what goes into performing base case evaluations and why they’re important for financial planning.
What Makes a Base Case?
Base case evaluations are a part of scenario analysis, which helps decision-makers visualize and compare the most realistic outcomes for a business. With foresight into all possible outcomes, an organization can greatly improve their financial planning and make decisions with confidence.
Simply put, in every scenario analysis, there are three key scenarios that must be identified: the best-case scenario, the worst-case scenario, and the base-case scenario. Typically, the base-case scenario falls between the two extremes and is fairly conservative.
In other words, nothing amazing or disastrous will occur in the base-case scenario, which is precisely why it’s so useful as a basis for comparison.
As an example, public companies can use base case evaluations to determine the viability of financing options or stock buybacks. Small businesses can use base case evaluations to better plan for constructions, expansions, new hires, and much more.
How is a Base Case Built?
All financial models rely on assumptions—which include things like inputs (or independent variables) and outputs (or dependent variables).
These assumptions are often based on historical data (e.g., previous sales history or costs of goods sold) or industry benchmarks (e.g., YoY average industry growth). If there is not enough historical data, the relationships between these variables are sometimes assumed as well.
To estimate next year's sales, for example, you’d make an assumption about the number of items you might sell based on your company’s sales history.
As an example, let’s say an independent video game store saw its sales increase by five percent from 2017 to 2018 and three percent from 2018 to 2019. These increases happen to fall roughly in line with the video game industry as a whole, which saw sales increase by two percent from 2018 to 2019.
It’s reasonable for the store owner to assume that sales will increase by more or less the same percentage in 2020. The shop owner uses a “base case” scenario for his 2020 projections in which sales increase by two percent for his store.
The Importance of Base Case Evaluations
Base case scenarios act as a “reference point” for business planning and provide leadership with a basis for comparison. Base case evaluations are particularly important in complex financial models, in which many different variables are tested against multiple scenarios.
Before getting started with base case evaluations (or any financial model), the objective needs to be clear.
For instance, let’s say the video game company is now gearing up for the upcoming holiday season. The owner asks his financial analyst to build a base case evaluation for this year’s expected profits. The analyst needs to consider:
- Cost of goods sourced from vendors
- Sales and profit estimates
- Customer foot traffic
- Merchandise return rates
- Operational overhead
- Seasonality (e.g., holiday sales)
Each of these inputs is an independent variable that can affect the outputs, or dependent variables. But not all independent variables are created equal. Some of the inputs will have more of an impact on the bottom line than others.
Put another way, the financial model is more sensitive to changes in certain variables and less sensitive to changes in other variables. The organization needs to determine not just the relationships between variables, but also how sensitive their model is to changes in each individual variable.
Base Cases Can (and Should) Change
If 2020 has shown us anything, it’s that nothing is ever 100% certain. Things can change completely when you least expect them to.
Nobody would have predicted last winter that a pandemic would drastically impact our daily lives. Small businesses have been hit especially hard due to government shutdowns, uncertain consumer behaviors, and drastic changes in business protocols.
Base case assumptions should change as circumstances change. However, in uncertain and volatile times, historical data and industry performance become less reliable. This is where the experience of the modeler or company leadership comes into play.
Our video game store owner, for example, asks his financial analyst to factor an estimated 40 percent sales drop into the new base case evaluations. He came to this conclusion using factors such as:
- The extended closures he’s seen over his 30 years in business, including the impact of the last two market crashes
- Social distancing rules that impact foot traffic outside his store as well as the number of customers allowed inside his store
- The continued industry shift toward online (downloadable) video games
One thing’s for sure: this year’s holiday season will be very rough. Minimizing costs will take precedence over maximizing profits.
Never Rely on Base Case Evaluations by Themselves
While base case evaluations show highly probable outcomes using the most likely conditions, they should never be your sole reference point. The more variables involved in a financial model, the more likely that the actual outcome can vary drastically from the base case.
Business leaders and analysts need to survey a wide range of possible outcomes, including their best-case and worst-case scenarios, in order to gain a complete understanding of their company’s future outlook.
Let’s say the video game company’s financial analyst estimates a 70 percent sales drop in the worst-case scenario and no increase in sales in the best-case scenario. The analyst uses a similar range for changes in foot traffic. Operational costs, however, have a narrower range of variations due to more stability in rent, utilities, and hours of operation.
Using this adjusted base-case scenario, the analyst can run a more dependable scenario analysis to identify important drivers and outcomes. For instance, the analyst may find that there will be low foot traffic until a vaccine is released, no matter what else happens.
Just a year ago, our business owner was considering expanding his shop to accommodate board games. Of course, there’s a threshold profit margin that, if reached, could make the expansion possible. Yet with a huge drop in profits all but certain, he’ll likely have to hold off.
Thanks to the realistic expectations established with the base case, the business owner can go into the holiday season with a focus on reducing costs.
Make The Most of Base Case Evaluations
In times of uncertainty, base case evaluations are like an anchor. They keep your financial outlook grounded so that you are never too surprised (or disappointed). That’s why companies should consider using better scenario analysis tools. Synario, for example, allows users to run an unlimited number of scenarios to gain a better understanding of their financial position.
Synario lets analysts drill down into micro scenarios to identify the drivers and levers behind every decision they make. Best of all, Synario eliminates the need to remake models from scratch whenever the board sends down new questions.
Thanks to Synario’s dynamic, automated visualizations, changes can be made to scenarios mid-presentation. Decision-makers can consider multiple future outcomes in one meeting and begin planning for the future with confidence.