How to conduct a financial stress test for small business owners

A financial stress test is a process business owners use to gauge how their companies would perform in difficult financial scenarios. Especially useful during times of uncertainty, such as our inflationary climate, the test is a tool for determining and then preparing for the worst. But you don't need to wait until a perilous business situation arises to conduct a test—the biggest benefit of performing one is that it allows you to plan for the future.

There are two key questions that drive a stress test:

1. Do you have adequate financial resources to survive a downturn of up to two years?
2. Are there any potential threats on the horizon that could negatively impact revenue?

To know the answer, you'll want to run some numbers.

How to conduct a financial stress test

Marketer and speaker Nev Harris recommends starting a spreadsheet with three columns.

In the first column, list all the revenue you expect to receive in the next year—that's recurring revenue. In the second column, list all of your anticipated expenses for the same time frame. And in the third column, list your accounts receivable—meaning money you've already billed for but haven't received—plus what you currently have in your business checking account.

Next, total all the amounts in each column. Then subtract your expenses (column No. 2) from your anticipated revenue (column No. 1) to see if your business can sustain itself on the money you have coming in. If the number is positive, you're in solid financial shape at the moment. And if it is negative, you can supplement it with whatever you have in column No. 3 to see if you can turn that negative number positive. Long-term, however, you may need to take additional steps.

Take action

If your basic financial stress test suggests that you're going to burn through what you have in your bank account quickly, you'll want to take action to prevent that. There are a number of things you can do, including:

• Prioritizing expenses and cutting back where possible
• Instituting a hiring freeze
• Negotiating longer payment terms with vendors

You can also work on shoring up the revenue side of the equation, such as:

• Improving marketing and promotion to attract new business
• Rolling out new offerings to tap into different markets
• Securing a line of credit as a backup plan should your bank account run low

“There are a number of factors that can contribute to financial stress, including unexpected expenses, slow sales periods, and competition from larger businesses," Shaun Martin, the CEO of Denver Home Buyer says. "By taking the time to do a financial stress test, you can identify potential problems early on and make necessary changes to keep your business afloat."

Mila Garcia, the co-founder of iPaydayLoans, conducted a financial stress test, starting with “analyzing what worked and did not work for our business over the past year." Then the company “began to pinpoint our most valuable and loyal customers, in order to create ways that make it easier for us to keep creating added value for them."

That is, the company looked at how best to ensure the first column of the analysis—incoming revenue—was increasing to more than cover the expenses in that second column.

Garcia said her team “also reviewed our marketing campaigns, so as to make sure that we were still targeting the best possible customers. Furthermore, we also looked at areas that allowed us to trim costs, in order to protect the business by creating stronger cash flow. And finally, we set realistic goals for our workforce to focus on, because businesses not only have to fight to win market share but also to retain it."

A more in-depth financial stress test

Beyond the basic three-column financial stress test are ones that account for market forces.

Kizik, which manufactures and markets shoes that can be put on hands-free, had millions of dollars of shoes en route to traditional shoe retailers in April 2020, immediately after the pandemic shutdown orders too hold, CEO Monte Deere says. Not knowing how long the stores would be closed or what to do with the additional inventory that was already arriving at retailers, Deere and his team ran a financial stress test to see how long the company could survive without sales.

“With a little help from our friends, we were able to pivot to selling online," Deere says. “We ended up selling the shoes in one year while the other method would have taken five. Without that data from the stress test, we wouldn't have been able to make such informed decisions so quickly, and how we dealt with this major setback is what saved us."

Deere detailed Kizik's stress test: “First, we had to determine our stress factors, so we used a PESTLE analysis as a loose framework [PESTLE is a marketing framework that takes into account the political, economic, social, technological, legal, and environmental factors that can impact a company]."

Deere and his team filled out an Excel spreadsheet with forecasts based on what they were seeing in the market as far as demand. “We were able to do the math ourselves and determine fairly accurate forecasts for what our costs would be at certain points in time for each relevant category to us."

The team color-coded results to convey how urgent or dangerous the results were to the survival of the company, Deere says.

The stress test took into account all the money the company owed, including commitments for ad spend, as well as the lack of income.

Although you have no control over the economy or pending legislation, or even your clients, by monitoring what's going on in and around your business, you can also spot signals that you might need to change course for the financial health of your company.

Understanding whether your finances can withstand a downtown of up to two years can help you make more informed decisions regarding your marketing and spending to ensure that your business remains successful long-term.