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While it is quite common to budget using three scenarios (optimistic, realistic and pessimistic) it may not be sufficient from a risk management point of view. These scenarios are often formed without the risk management team’s participation or even without due consideration of the actual risks, associated with the budget. Thus, even the pessimistic scenarios often do not account for many significant risks, creating an overly optimistic and misleading picture for the executives and decision-makers.
Proper risk analysis can bring significant value to the budgeting process. Risk managers should review and improve management assumptions used in scenario analysis or introduce the use of simulation modelling to make sure all important risks are captured and their impact on liquidity assessed. Risk analysis helps replace static, point in time, budgets with a distribution of possible values. It also helps set management KPIs based on the risk information, thus improving the likelihood of them being achieved and reduces the conflict of interest the finance department and management team have in presenting an overly optimistic budget. Risk analysis helps to identify the most critical risks affecting the budget, allowing management to allocate ownership and determine the budget for risk mitigation.
Integrating risk management into the budgeting process requires the risk management team working closely with the finance department, as risk analysis may lead to the change in budget assumptions or targets.
HERE IS A QUICK CHECKLIST TO TURN THIS SECTION INTO ACTIONS
| ☐ | Review existing policies and procedures covering budgeting process to determine whether risks are adequately taken into account |
| ☐ | Test the existing budget model using sensitivity or scenario analysis to determine whether risks are adequately covered |
| ☐ | Perform simulation modelling on the budget model to determine the likelihood of objectives being achieved as well as to identify any liquidity problems |
| ☐ | Determine the most significant risks that affect the budget and risk mitigation measures |
| ☐ | Adjust the budget based on risk information |
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