Reverse stress testing (RST) aims to provide useful information about vulnerabilities in a firm’s business model and strategy. ICAEW outlines a step-by-step guide on how to complete an RST.
RST is a systematic process of finding weaknesses in a business and deciding on the action that needs to be taken. Unlike conventional stress tests, RST starts with the identification of a pre-defined outcome - the point at which the entity’s business plan becomes unviable - and considers combinations of adverse circumstances that could cause the failure of the business. Completing an RST can help when designing measures to prevent and mitigate the risk of business failure.
Five steps to carry out an RST
- Identify the pre-defined outcome to be tested
- Identify a range of adverse circumstances which would cause this outcome
- Quantify the financial deficit which would cause the pre-defined outcome should the identified adverse circumstances occur
- Assess the likelihood that such events could occur
- Mitigate the risk
Traditionally in RST this might be the point at which the entity fails. For practical use in going-concern assessments, this is likely to be when an entity:
- runs out of cash;
- is requested to repay a loan; or
- where loan covenants that have not been waived are breached.
The severity of each scenario should be considered.
Financial resources required will depend on the severity of the scenario.
Assess the likelihood of events included in the scenarios leading to the pre-defined outcome. RST commonly refers to plausibility. Stress events observed in similar environments outside the entity should also be considered.
Where the above steps reveal a going-concern risk that is unacceptably high in terms of the entity's risk appetite, the entity should adopt effective processes, systems or other measures to prevent or mitigate that risk. This should take into account the time that the entity would have to react to the events and to implement measures mitigating the risk, including considering changes to the business model.
A wide range of scenarios should be considered. They are likely to include non-financial scenarios, that when reverse stress-tested lead to the adverse outcome. For example:
- An entity’s regular supplier has suddenly ceased trading, forcing it to source alternative suppliers. The product provided by the new suppliers is of a lower quality, which has led to reputational damage for the entity. This has a knock-on effect of higher than usual levels of refunds and warranty claims.
- Higher instances of phishing and other cyber attacks have led to a publishing entity’s intellectual property being made available as open-access.
How can the point at which the business model fails be identified?
The Financial Services Authority’s 2011 ‘Reverse stress-testing surgeries FAQs’ notes that entities may start to develop scenarios that lead to the business model failing by considering the cause, consequence or impact (financial or otherwise) of one or more events that lead to the failure of the entity.
Entities should note that ’failure’ can occur well before the point at which the capital or liquidity of the entity is exhausted. For example, it may be the point at which:
- market participants see that the entity is over-exposed to a particularly risky sector;
- the market loses confidence in the entity, resulting in the refusal of market counterparties to deal with the entity, or under such onerous conditions that it is economically unviable for the entity to carry on its business activities.; or
- the entity is unable to transact any new business and its revenue streams dry up, or shareholders are unwilling to provide new capital (impact). The impact might also be that a loan covenant is breached.
Entities might consider any one of these as the ‘pre-defined outcome’ from which to develop the scenarios.
Entities should also consider that the pre-defined outcome of reverse stress testing can be produced by circumstances other than the circumstance analysed in the stress test.
Scenarios where management might consider in carrying out RST?
Operational
These factors might be considered by management and used to fine tune the revenue and cash flow forecasts. A RST approach will then allow management to determine the level of decline in revenue which would lead to the predetermined outcome, ie running out of cash.
Management can develop mitigations by assessing how much lower this level would be compared with its downside forecast, and base case scenario.
- Demand for luxury products has decreased.
- A major market participant has failed
- Inability to obtain parts for (or servicing of) equipment key to the entity’s trade.
- One or more key suppliers have reduced levels of activity or ceased to trade. This may be compounded if you have previously built up a reliance on outsourcing.
- Supply-chain disruption due to extreme weather event.
- Conduct-related risk and litigation risks have arisen.
Structural
- The fixed cost base is hard to reduce. A significant property is still incurring rent or mortgage payments, but not generating revenue.
- Cash flow limitations.
- Repayment of a loan (without covenants) is demanded.
- Loan covenants are breached, and repayment is required, as the lender has not waived the covenants.
- If there is a temporary hold on the payment of dividends by companies, whether it is enforced by regulators or otherwise, the company may be a less attractive proposition for shareholders.
- A parent entity is providing support, but there is going concern uncertainty for the parent as well, or they may be supporting other subsidiaries too.
- There may be constraints affecting the transfer of funds between jurisdictions or group entities, which might affect intragroup liquidity transactions, depending on the location of the funds.
Financial
- Insurance provider will not provide cover.
- Assets and liabilities, including off-balance-sheet items, might be in another currency which might not be easily convertible due to possible disruptions in the access to foreign exchange markets.
- Commitment to incentivising in compensation schemes.
- Wider economic factors, such as a fall in the availability of government support.
These factors may induce further reputational consequences. Actions that the entity may take to mitigate losses might have their own reputational impact, including paying suppliers more slowly or seeking faster recovery of debtors.
What time horizon might be considered?
Entities should be assessing their ability to continue as a going concern for a period at least as long as that required by the applicable financial reporting framework for the purposes of preparing their financial statements, and therefore management’s model will need to consider these different time horizons.
An entity may consider conducting reverse stress tests more frequently if there are substantial changes in the market or in macroeconomic conditions.
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