CFOs should adjust to worries about rising prices — underscored by an eightfold surge in mentions of inflation on earnings calls — by taking four steps, ranging from subjecting forecasts to stress tests to weaving high-risk factors into scenario planning, according to Gartner Finance.
“Rising inflation and persistent supply chain issues are adding a new layer of complexity as CFOs and their business partners develop forecasts for the upcoming year,” according to Vince Keenan, senior director of research at Gartner Finance. “Right now, forecasts for many industries will include volatile inputs that may significantly change the forecasts that companies share with the investment community,” he said.
Federal Reserve policymakers Wednesday signaled their intention to curb inflation by raising the benchmark interest at their next meeting on March 15-16.
“Inflation has persisted longer than we thought, and of course we're prepared to use our tools to assure that higher inflation does not become entrenched,” Fed Chair Jerome Powell said at a news conference. The central bank aims to reduce inflation to its 2% goal, he said.
Like Fed officials and most private economists, many CFOs and their C-suite colleagues did not anticipate a 7% leap in the Consumer Price Index last year, the fastest pace since 1982. Price gains exceeded 6% in each of the final three months of 2021.
C-suite executives have elevated inflation to their No. 2 external threat from the 22nd ranking a year ago, the Conference Board found in a survey during October and November of 1,614 C-suite executives worldwide, including 917 CEOs.
“Inflation concerns are skyrocketing,” the Conference Board said. More than half (55%) of CEOs worldwide predict high price pressures will persist until at least mid-2023.
Gartner said CFOs should respond to worries about price pressures and quantify inflation risks for investors by taking four steps:
1. Identify assumptions that will influence performance this year
Acting internally, finance teams should reach out to their colleagues in operations, procurement, product management and human resources to uncover any risks that could increase costs or erode revenue.
Such risks may include commodity prices, component availability, transportation costs, overtime, one-off bonuses and use of temporary staff and recruiters or agencies, Gartner said.
“Inflation is a topic that the investment community has not dealt with for many years,” Keenan said in an email response to questions. Shareholders “appreciate a candid assessment of potential impacts from management since this is not something they are used to modeling.”
CFOs can also include in their forecasts credible price assumptions based on third-party indexes or government data.
“With many cost factors outside the CFO’s control, pointing investors to third-party data sources allows management to provide investors insight into cost drivers without making predictions,” Keenan said. “The goal is to educate investors on external risk while emphasizing the steps the company is taking to mitigate them.”
2. Stress test forecasts
A CFO should ensure FP&A staff stress test the business model to identify the factors that pose the highest risk to the most important financial metrics, including revenue, gross profit margin and operating income margin, Gartner said. Such efforts would clarify the risks to company forecasts of revenue and earnings per share.
3. Build scenarios that isolate the highest risks
CFOs should draw up scenarios based on the highest risks, incorporating the estimated savings from risk mitigation or cost reduction. Such examples will help CFOs estimate how much of the negative impact they can offset in the coming year.
For example, a logistics company might estimate that its operating margin would fall by as much as 0.015 percentage point for every 10% increase in the price of fuel, Gartner said.
CFOs frequently focus on revenue scenarios because “growth and earnings power has been the focus of investors leading up to the pandemic,” Keenan said.
Currently, “many industries are dealing with multiple external risks that could impact their financial performance,” he said. “That is why our recommendations go beyond simple scenario planning to include a stress test and scenario analysis to isolate the most impactful risks.”
4. Inform investors about external factors that might prompt a guidance change
When providing guidance, CFOs should flag outside factors such as demand trends and supply chain bottlenecks that could most influence financial performance, both positively and negatively. They should identify any corresponding index or government statistic that investors could track.
“The goal is to understand the risks, develop mitigation plans and then share this insight with investors to prepare them for a potential change in guidance,” Keenan said.
“Investors do not like surprises, so every CFO should provide additional context to their guidance that identifies risks outside the company’s control and highlights the mitigation plans that will offset some or all of the impact,” he said.
CFOs would be wise not to share every category of data, Keenan said.
“Avoid granular details and not share any data points that they would not be comfortable updating in the future,” he said. “That is why I recommend a simple scenario analysis that shows how an input change can impact a key financial metric, i.e., an increase of 10% in a key input cost would create an XX percent decline in operating income margin.
“I expect there will be follow-up questions on the earnings call where management can provide more color on the dynamics of the business model without sharing additional detail,” he said. “Most investors are focused on revenue, margins and EPS so there is no need to drill down further.”
Gartner Finance found an eightfold increase in mentions of inflation when tracking references to terms related to price pressures during earnings calls by companies in the Standard & Poor’s Global 1200 Index from the third quarter of 2020 through the third quarter of 2021.