Scenario planning – a case in point

Posted on 14 Dec 2023 by The Manufacturer
Partner Content

The UK economy is making a slow recovery, according to some, whilst others suggest there is still a risk of recession. The uncertainty can be worrying for many small and medium-sized firms, but these businesses can reduce the potential risks.

In this second article on building resilience in the manufacturing sector, we use a real example to illustrate the true value of effective scenario planning and how a bank like Allica can partner with manufacturers to help them prepare for future growth, even during challenging times.

Too good to miss

During the 1980s, China’s construction sector was booming. A British manufacturer of safety apparel for construction workers was excited by the potential opportunity it saw, particularly when the European market was saturated and becoming increasingly competitive.

The senior management team discussed the pros and cons of the market opportunity and decided it was too big to ignore, so they decided to build a manufacturing facility to supply directly to local firms. During their scenario planning session, they recognised there were difficulties because any business operating in China needs to incorporate a foreign investment enterprise and obtain a licence through the local government. They, therefore, decided to set up a joint venture with a Chinese enterprise; it proved to be a costly mistake.

Unfortunately, the Chinese partner stole the manufacturer’s IP, copied its production process and sold into the market themselves. Ultimately, the UK firm had to write off close to a million pounds, and it took the firm five years to recover.  With hindsight, the senior management realised there wasn’t any need to be in China at all.  Instead, the safer route would have been to expand manufacturing facilities in Europe and promote its products to European businesses already selling into China’s construction industry. The road into China would have been indirect but far less risky.

The pitfall of planning

The real question is, why didn’t the management team explore this option during its scenario planning? It is a common pitfall called availability bias. The management team had so much data on the growth of new construction projects, the market, etc., that it caused a collective blind spot in the minds of the senior executives; all they could see was an opportunity too good to miss.

Also, whilst they recognised language, local laws, and the need for Chinese Communist Party (CCP) local government approval were barriers to entering the market, one the joint venture was seen to address, they missed the next critical question – what could go wrong? As is very typical with many firms, other problems with a low probability of happening, such as the partner stealing the company’s intellectual property, were overlooked or dismissed, even if they had been considered.

Had the manufacturing company involved their business banking partner early in the planning phases, the risks of joint venturing into China would have been explored more thoroughly. Banks are very good at assessing and managing risk. They challenge the management team to consider the most unpalatable but plausible scenarios for the future, such as what if you lose 40% of your customer base tomorrow? What if your current supply chain suddenly collapses? What if you fall out with your joint venture partner?

A hostile environment

Any management team can test how realistic their plans are by using a simple pestle analysis on a whiteboard as part of their scenario brainstorming. This encourages senior executives to look at the political, environmental, economic, legal and technological trends that are happening today and consider the impact they may have on the business in the future.

The process inevitably produces more forward-thinking yet realistic scenarios and reduces underlying assumptions based simply on past performance or experiences. A good banking partner will help challenge those assumptions and how realistically management has evaluated what is and is not within the company’s control or whether it is blinded by over-confidence or over-optimism as happened in this case.

If this British safety equipment manufacturer had done so, they might have realised that partnering with a Chinese company in a communist country is inherently risky because of the political environment and the tendency for the politicians to fiercely protect their local interests. It is a level of protectionism that leads to behaviours not seen so often in the West.

Assessing risks

Small and medium-sized firms are generally inherently optimistic. They are driven by an entrepreneurial spirit and a belief that they can tackle any challenge. Some larger, more well-established SMEs still have that spirit but can suffer from stability bias, i.e. shying away from too much change. Yet, blue-sky thinking encourages growth. Asking ‘what if’ in these fast-moving times, looking forward to opportunities and threats such as ‘What if 90% of the workforce is replaced by AI?’ can be terrifying for any manufacturer.

But banks can help companies see the positive side of investing in new markets and plan ahead for any new plant and machinery, secure the funding and ultimately help the company remain competitive. Timing is critical, and discussing those one-, three-, or five-year plans early with the bank will help the plans come to fruition whilst minimising the risks.

Investing in a Chinese joint venture was inherently risky and meant the bank couldn’t offer the British manufacturer a commercial mortgage. Had the company’s plan been to build another factory in Europe the bank would have been able to provide the funds using the physical assets as security. But not in communist China. Instead, the firm used its own balance sheet to finance the joint venture and build its new production plant. The bank, keen to support the company, did, however, fund the company’s working capital.

Securing finance

Many SMEs use overdrafts to help fund working capital, i.e., paying creditors and managing debtors and stock. Many firms mistakenly treat overdrafts as cash and use them as a long-term source of financing to acquire plant and machinery. Often, the decision is reactive, driven by the need to secure a short-lived discount or good offer on the price.

But over time, it is a risky financial strategy. Overdrafts can be withdrawn, or terms changed at any time by the bank. A term loan, on the other hand, cannot be withdrawn or changed during the contractual period of anything between five to 25 years, which provides the business with stability.

Using an overdraft to fund plant and machinery also reduces the company’s working capital.  When debtors or sales increase and more stock is needed to meet customer demand, it often forces the company to seek a larger overdraft or another source of financing.

Banks can offer more stable sources of finance. Assets that contribute to the longer-term profitability of the business can be match-funded using tools such as term lending, asset financing, or hire purchase. Often, assets can be bought and leased back to the firm so the overdraft can be re-paid and once again be a source of working capital.

Discussing ambition

Instead, approaching a conventional credit provider like Allica Bank early on to discuss the ambitions of purchasing expensive plant and machinery, for instance, enables the bank to agree on financing terms and make the money available to be drawn down when it’s needed. It is often when reputable banks are approached at the last minute that firms find they are refused help. This drives them to other providers where the loans are unsecured, interest rates can be 25% above base rates, and there is no due diligence, so companies become over-leveraged and at greater risk of insolvency.

Ironically, asset finance, even a £2m loan or more, will only take a few weeks to arrange if management has a well-thought-through business plan. Larger loans over longer periods of time, such as a commercial mortgage, can be just as quick. On the other hand, it may take months to organise if the bank has questions about the plan’s underlying business and financial assumptions or needs more information to assess the risk to the company. In the end, the bank may recommend a more appropriate financial product than the management originally requested.

The role of a good banker is to ask the tough questions because they don’t want to put a company in financial jeopardy. Even if lending to the business appears to be too risky, the bank can often help by finding enough evidence that any debt will be serviced and open up finance opportunities rather than simply layering more debt onto debt. The relationship manager may discuss how and when to introduce the next round of debt to support the business through the next two or three steps and the right amount.

Every Allica customer with a current account has a dedicated client relationship manager who will also always encourage an SME to save however much they can afford and advise on current accounts or savings accounts with good interest rates, which can vary enormously. They can give guidance to management on investing as well as loans and working capital flows, etc.

But relationship managers can also facilitate useful introductions to experts in R&D tax credits, operational resilience and cybersecurity, for instance. Ultimately their role is to offer support and provide companies with confidence by building resilience, and the belief to invest and grow, in even some of the toughest business environments.

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About the author

Gareth Anderson, Head of Business Management at Allica Bank

An experienced corporate and commercial banker, Gareth has spent 17 years working in banking and financial services, with much of that time spent working closely with SME’s both as a Relationship Director and in various leadership roles across client facing and product teams.

Having spent years working with companies across sectors from manufacturing, retail & wholesale, technology and healthcare, Gareth’s passion is on supporting the plans and financial ambitions of SME business owners, helping them build resilience into their business models to navigate through times of uncertainty.