After the banking disaster in 2008 the United States government stepped in and required many US banks to undergo what they called “stress tests.” In a very simplistic sense, these stress tests were simply glorified what-if scenario analysis. The purpose of the stress tests were to determine whether the banks could survive without government intervention if certain scenarios occurred. For example, what if unemployment reached 15%, or what if foreclosures increased by another 25%? How would the bank handle these scenarios? Would they be able to stay solvent, and what would they have to do to stay in business?
I think there are at least 3 reasons why entrepreneurs should consider stress testing their own business.
1. It Keeps You from Getting Comfortable – What is one of the most dangerous positions for a small business to be in? Comfortable. When things are going well, you have found a business model that works, and you are just coasting along raking in the profits, that is when you should be pushing to innovate. By performing a stress test you will be able to see how your business could be negatively impacted by outside forces. In theory this should keep you on your toes, force you to stay relevant, and help you avoid getting comfortable.
2. It Can Keep you Diversified – As you run various scenarios you might find that you are incredibly reliant on one specific customer, one piece of technology, one constantly fluctuating raw material, or one employee. A common example is a website that is heavily reliant on their Google search ranking. If your business relies on your search engine ranking, you need to start to diversify because the Google algorithms will change. In the same way, if your business model crumbles when oil prices rise 20%, you need to diversify your business so that you can withstand fluctuations in the economy and commodity prices.
3. It Prepares You for the Worst – By stress testing your small business you can develop a plan to stay afloat when 2008 happens again. What if the credit markets freeze? Will you be forced to close up shop, or can you plan ahead now so that you are ready with targeted and timely changes that will keep you from shutting your doors? You shouldn’t live in fear while business is going well, but you also should not ignore the fact that things can change quickly. Pull together a financial projection spreadsheet with a number of different variables and run some scenario analysis. For example:
- If – Gas prices reach $5.50 a gallon, where will you make cuts to balance the budget?
- If – Sales drop 50% during economic uncertainty, which expense line items will you cut, and by how much?
With more bad news coming out of Europe every day, it is probably time to stress test your small business, and set yourself up to weather any Eurozone storm. Stress testing will keep you focused, diversified, and help you plan for the worst case scenario before you are hit with another 2008-like surprise.
About the Author: Adam Hoeksema is the Co-Founder of ProjectionHub. ProjectionHub is a web application that helps small businesses create financial projections without the need to have a PhD in spreadsheet modeling.