Market factors are increasingly contributing to volatility in the business environment. While long-term planning is still key, scenario and sensitivity analyses are becoming more important tools for the C-suite.
Financial analysts determine when to use scenario analysis vs. sensitivity analysis to predict future results. In turn, business leaders can determine the impact of certain business decisions. Both analyses help companies gain a better understanding of their potential outcomes. Ultimately, both scenario and sensitivity analysis help companies forecast more accurately and reduce risk.
What is scenario analysis?
Financial analysts use scenario analyses to sort through a range of potential future market and economic conditions. These might include shifts in tax policy, supply chain issues and disruptions from technology and competition.
Scenario analysis can also be used to forecast different outcomes based on the potential results of certain investment and business decisions. This process will often give clarity around best-, middle- and worst-case scenarios. In turn, business leaders can plan for a variety of outcomes and make nimble decisions to meet growth targets or other goals.
How to conduct scenario analysis: An example
A hypothetical real estate development company is considering investing in a shopping center. To determine the investment impact, a financial model using scenario analysis would help examine the most likely outcomes given certain assumptions.
A financial analyst would conduct this real estate company’s scenario analysis by:
1. Building a base-case scenario. This would include the company’s accepted assumptions about the future. It would also use all inputs related to the shopping center investment, such as projected revenues, various expense lines and cost of capital.
2. Adjusting certain inputs and assumptions to build multiple scenarios. Inputs and assumptions would include the capital investment, other cash outflows and projected revenue growth. Scenario outputs would usually include best case, worst case, and one or two others.
3. Analyzing metrics from the financial model. The model would provide important valuation metrics such as internal rate of return (IRR), payback period and net present value (NPV) to help assess the return on investment.
4. Providing decision-makers insights from the analysis. If the most probable scenarios indicated the targeted IRR would be achieved, leaders would likely consider moving ahead with the investment. Typically, a company would want a higher IRR than its cost of capital. The real estate development company with a theoretical 10% cost of capital would want to invest in projects that have higher returns than that amount.
Scenario analysis vs. sensitivity analysis—what’s the difference?
A scenario analysis can involve many assumption adjustments at the same time. In other words, scenario analysis looks at how different values of a set of independent inputs affect a dependent variable.
Sensitivity analysis can also be helpful to quantify and analyze different outcomes. However, it differs from scenario analysis because sensitivity analysis only alters one input. It then shows how sensitive the projections are to that variable.
If a finance director at a software company wanted to see the impact of a 1% change in annual sales of the top-selling product [the variable input] on the company’s annual cash flow or profitability [the projections], he could use sensitivity analysis to focus on this one assumption.
Why use scenario and sensitivity analysis?
The value of scenario analysis
Scenario analysis can be useful when a company is assessing whether to make an investment. It can also be used to determine what’s necessary to increase revenue and profit by a certain amount. For example, a specialty retailer may look at how many new stores it needs to open next year to reach its financial goals.
This financial analysis can provide best-case, base-case, or worst-case scenarios—and other ones in between. This can add value when making important decisions about business strategy and investments. A detailed scenario analysis may show that while opening up a certain number of new stores would help the retailer meet revenue goals, margins would likely suffer.
The value of sensitivity analysis
On the other hand, sensitivity analysis can help a financial analyst assess how much a single input affects the business. For example, if minimum wage were to rise by 2%, how much would it impact the specialty retailer’s labor expenses? The sensitivity analysis would illustrate the effect on profitability and cash flows.
These financial projections would assist managers in making optimal business choices because expected results have been quantified with adjusted assumptions.
Is it better to use sensitivity and scenario analyses together or independently?
In many situations, a company can benefit from using both scenario and sensitivity analyses together to get a comprehensive view of potential outcomes.
Let’s return to our hypothetical example of the real estate development company considering a shopping center investment. The finance team may model a few scenarios, from best to worst.
Sample Best Case Scenario:
- Lower initial investment expense
- Strong economic conditions
- Better than average revenue growth
Sample Worst Case Scenario:
- Deteriorating economy
- Lower revenue growth
- Expenses going over budget
The financial model would show how the two scenarios would affect projected IRR and payback period for this investment. Sensitivity analysis could provide more nuanced information within one of these scenarios. This might include assessing how increasing a single expense line would impact the project ROI.
The company could also run sensitivity analysis to identify which data inputs would have the biggest impact on the financial model’s desired output. These outputs could broadly range from annual earnings per share to expected return on investment.
A standalone sensitivity analysis could provide greater clarity around the importance of a single input in the financial model. For example, if the finance manager wanted to hone in on exactly how much one input, such as advertising expenses, would affect the desired output of annual projected earnings per share, she could use sensitivity analysis. This could help give clarity into how much any changes in advertising expenses would affect the development company’s earnings.
Use scenario and sensitivity analyses to stay nimble and make proactive decisions
Scenario analysis and sensitivity analysis can help companies anticipate how key variables could impact the company’s growth and results. The future can be unpredictable, but leaders can better prepare for a range of possible outcomes and intelligently position the business through proper analysis.
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