What is Financial Contingency Plan? A Step-by-Step Guide to Creating One

Creating a financial contingency plan is a wise move for any business. Crises and setbacks can strike suddenly, from natural disasters to economic downturns, technical failures, partner bankruptcies and customer desertions. Contingency planning lays out, in advance, how to quickly respond to each of these scenarios and get the business back on track.

What Is Financial Contingency Planning?

Contingency planning, in general, is about prioritizing the actions you should take in the face of extraordinary threats to your business. What are the first steps you should take in a crisis? If those aren’t enough, what are the next steps?

Financial contingency planning is an aspect of contingency planning that focuses on the financial resources necessary to keep the company solvent and operational when a crisis occurs. For example, it may identify ways to raise funds or cut costs if there’s a sudden drop in revenue due to an economic crisis.

What Is a Financial Contingency Plan?

A financial contingency plan identifies your company’s worst-case scenarios and their impact and presents potential responses. Companies typically develop financial contingency plans by gathering and analyzing data, then handing it off to senior managers and executives who brainstorm strategies. A business may also hire a consultancy for this specific purpose.

Typically, an organization develops financial contingency plans for each of perhaps a half-dozen risks chosen by the group. When a crisis occurs, the company uses the contingency plan as a playbook.

Why Are Financial Contingency Plans So Important?

Financial contingency plans provide the foundation for mitigating business risk, speeding up disaster recovery and ensuring business continuity and resilience. The COVID-19 pandemic has put a new premium on companies establishing this resilience, in particular their supply chain resilience, according to analysts.

Contingency planning comes with a strong business case, because companies that can respond effectively to a crisis and quickly get back on their feet could gain a competitive advantage over other companies.

Benefits of a Financial Contingency Plan

Staying solvent and maintaining near-normal business operations may be the most important benefits of a financial contingency plan, but there are other important advantages it provides. One is the emotional benefit, since planning ahead can reduce stress and panic during an actual crisis. With a clear plan in place, your team can swiftly turn its focus to action in the midst of a challenging and often dynamic situation.

There is also the reputational benefit, as responding effectively in crisis reflects well on your company. Even if you never have to put the Plan B into action, the fact that you have a well-crafted financial contingency plan can make customers and other stakeholders more comfortable.

And keep in mind that financial contingency plans are not just for worst-case scenarios. They can also address best-case scenarios, like a flood of new online orders that you don’t have the capacity to fill. In that way, financial contingency planning can also help companies fully capitalize on their success.

Finally, while you cannot plan for every crisis or setback, once you have a few tested financial contingency plans in hand, you may be able to apply their action items to other potential scenarios.

What Is Included in a Financial Contingency Plan?

Financial contingency planning has two critical goals. One is to address the immediate response to the crisis; the other focuses on normalizing operations after the event has occurred, or in areas of the business untouched by the crisis. For example, a short-term response to a financial crisis in a core business unit might include tapping into an existing line of credit; a longer-term response might involve diverting spending from complementary or unprofitable units to the core business area at risk to help it bounce back.

The chapter and verse of a financial contingency plan will vary based on the size and type of business. In general, a plan should include options for marshaling resources and/or cutting costs. The financial levers you should be prepared to pull might include:

Funding: Cash reserves are king in crisis situations. Although experts suggest businesses hold enough cash or other highly liquid assets to cover six months of operating expenses, studies show that many smaller businesses don’t do that. Access to lines of credit, short-term loans and business continuity insurance are a few other funding sources companies should secure in advance of any crisis.

Costs: Expenses, staff and even entire business units can be cut or sold in an effort to protect profitable activities and maintain positive cash flow.

Accounting software with detailed reporting and data visualization tools can help paint a clear picture of your financial situation as you weigh the options best for your organization, as it draws on live data from your enterprise resource planning (ERP) system and other tools.

Example of a Financial Contingency Plan

It’s all too common for companies to depend on one customer for a big slice of their revenue, which represents a major risk and demonstrates the importance of contingency plans. If, for example, you get 25% of your business from a single customer, you should have a contingency plan for that customer’s possible defection. The financial components of such a plan could include:

• Arranging access to short-term credit with your bank in advance to cover any revenue shortfalls.
• Understanding options for renegotiating extensions to existing business loans.
• Taking steps to accelerate payment from other clients, such as renegotiating payment schedules and collecting on past-due accounts.
• Laying off staff associated with the lost client’s business.

Longer-term responses might include reducing discretionary spending, cutting unprofitable operations and doubling down on new business development to replace the lost revenue and making your business less reliant on that one customer. Core business areas should be protected from cuts that might damage their profitability to minimize the impact on the rest of the company and maintain “business as usual” wherever possible.

7 Steps to Create a Financial Contingency Plan

Businesses should take a methodical approach to building a financial contingency plan in order to ensure that it adequately covers the biggest risks. Here are key steps in that process:

1. Identify risks. Narrow down your company’s risks to five or six realistic scenarios that could truly derail your business. How likely are they, and how severe would their impact be?
2. Analyze causes. Understand and document why each of these situations might emerge.
3. Track indicators. Based on this analysis, list the possible signs of trouble and come up with ways to track them to stay ahead of the situation.
4. Prescribe actions. Detail the strategy for responding to each crisis by specifying and prioritizing which steps to take, how, by whom and in what time frame.

As you develop the outline of your contingency plan, delve more deeply into each of the risks, the financial resources available to you and how you can use those resources to respond:

5. Analyze your financial profile. Use all the financial planning and analysis tools you have to detail your operations and the markets you serve, including costs, cash flow and competitive positioning. This can give the company insights into the likelihood of various scenarios and their potential impact.
6. Inventory your assets and funding sources. Ask yourself these questions: How much do you have in cash reserves? Which assets are indispensable and need to be protected? Which assets would you consider shuttering or selling? Where could you cut spending without risking profitability? How much can you borrow quickly? Do you have business interruption insurance?
7. Make plans to reallocate, cut or leverage. Answering the questions above might suggest dipping into your reserves—usually the first and best option—or scaling down production, using lines of credit with your bank or selling a non-core business unit. Each option should be rated for its speed and reliability to raise funds. For instance, selling a business unit might have a slower, less-certain outcome than taking out a short-term loan when time is of the essence.

The following best practices can also help optimize the development and maintenance of your financial contingency plan:

• Activation: You should have a policy in place that describes exactly when a contingency plan would be activated—including the decision-making process and who is involved.
• Reviews: Examine these plans on a quarterly basis, considering economic shifts and workforce changes, to account for economic factors or other issues relating to the business such as new contact details or a significant change in cash reserves.
• Communication: Make sure the plan is communicated to select individuals in your company across departments so they can review and understand it before any crisis materializes.
• Learn from experience: As with any good business plan, companies should learn from experience whenever they turn to the contingency plan and make adjustments that will put it in a better position for the next crisis.

Free Financial Contingency Plan Template

A variety of tools are available to help you develop a financial contingency plan. You can start brainstorming your response to crises by downloading this top-level financial contingency planning template.

Additionally, accounting and data analytics software often have planning and visualization tools that help organizations map out risks and financial responses. Those could assist in preparing for the unexpected by facilitating activities like:

Trend lines: Monitoring critical metrics over time, such as cash flow and accounts receivable, may provide early warning signs of a major setback for your business.

Mind maps: Mind maps organize and categorize the wide range of risks your company faces, to help you winnow them down and prioritize the biggest threats.

Risk impact charts: These charts organize risks based on their impact and probability of occurrence, to help you prioritize responses.

Decision diagrams: Decision diagrams visually map specific responses to specific events, giving leaders a clear plan of action during a crisis .

From risks as varied as losing a major customer to facing a natural disaster, developing financial contingency plans will help serve as a playbook for your organization to navigate the crisis.