The value of stress testing your budget – a case study for decision-making

The COVID-19 pandemic continues to evolve as a dynamic situation for local governments. Strictly from a budgetary perspective, the global health crisis and subsequent economic shock will certainly cause strain, but how much? This is a question that can only be fully answered in hindsight, but governments do have access to tools that can provide valuable insights about what to expect and to enable response planning. And, while many have commented on the importance of cash flow modeling, less attention has been given to the critical linkage of cash flow modeling and operational decision-making.

One city in Kansas conducted a “stress test” on their general fund budget. Stress testing is a highly valuable output of cash flow modeling tools. To account for uncertainties in the available data, the city developed three possible economic scenarios: a “V”-shaped, a “U”-shaped, and an “L”-shaped recovery from the present economic and fiscal shock. These scenarios represent a quick economic recovery, a slower recovery and a failed recovery, respectively.

The city considered how these scenarios would impact each of their revenue streams as well as the demand for services. They then quantified the additional expenditures and tallied the estimated lost revenue from their baseline economic model through 2024. The city considered what budget adjustments they had available to them: staffing and service levels, potential expansion of more viable revenue sources and available cash reserves, among many others. They also considered how difficult it would be to implement these adjustments operationally, legally and politically.

Using this scenario-based approach, the city was able to judge whether their general fund budget was able to withstand certain economic shocks. The chart below demonstrates the budget solutions available to the city versus the additional expenditures and lost revenue, labeled collectively as “value at risk” over the coming five-year period.

The stress testing revealed that the city would be able to withstand an economic shock with moderate impact to operations if the recession is brief. However, more difficult decisions will need to be made if the economic impact is more severe.

This case study demonstrates the value of these models to the degree it clarifies the causes, effects and scale of the problem facing management and the governing body. Analytical models and organizational management efforts are most valuable to an organization when they:

• Define and produce scenarios for key revenue and expenditure budget drivers
• Link revenue sources, where possible, with service expenditures, potentially at different service levels
• Illustrate the levels and impact of using cash reserves
• Enable investigation of new approaches to funding and/or timing of capital improvements
• Incorporate stress tests to quantify potential financial outcomes under alternative sets of assumptions
• Support dynamic modeling that is easily adjustable to rapidly changing conditions

The earlier this type of analysis begins, the more deliberate the decision-making process can be, and the more swiftly remedial actions can be identified and adopted. These actions can include:

• Development of a clearly defined remediation strategy and plan to address identified shortfalls
• Implementation of cost containment measures
• Examination of the organization and its staffing levels to reduce redundancies, right-size structures and redeploy personnel to their best use
• Redesign of business processes to improve cycle times and eliminate errors
• Engagement of the workforce in operational improvement initiatives
• Optimization of available technology tools

For more information on this topic, or to learn how Baker Tilly public sector specialists can help, contact our team.

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