In our last article, we discussed the different forecasting techniques that one could adapt to their business and help with financial planning. Investors and banks look for businesses that can sustain risk and can produce accurate data to represent their future, therefore it is important to create in-depth forecasts and financial plans that take all sorts of data into consideration. However, most forecasting techniques can turn out to be quite inaccurate and misleading if not supported by enough data.
While business and corporate forecasts and financial plans don’t always result in 100 per cent accuracy. This is especially true if you are running a quantitative forecast, which is only based on your past performance and can only predict the patterns in your demand, rather than the possible demand of the future.
In this case, a sensitivity analysis is useful, as it allows to stress test the financial results and tells the assessor how each variable can be influenced. It allows to understand how much room the business has for each variable to go wrong, thus helps in assessing the risk of investing.
Today we are reviewing the importance of sensitivity analysis as a way to incorporate several different performance possibilities into your financial plan and benefit your business investment opportunities.
What is sensitivity analysis?
Sensitivity analysis is often used as a part of financial plans to examine how different values of a set of independent variables affect a specific dependent variable under certain conditions. Or simply, how different occurrences can affect the P&L and balance sheet – how sensitive your financial results are. Especially, sensitivity analysis concentrates on looking at the profits in P&L and the credit needs in the balance sheet. Also, sensitivity analysis is commonly referred to as ‘what-if’ analysis by financial analysts used to predict the outcome of specific actions under certain conditions.
Sensitivity Analysis vs Scenario Analysis
While similar, it is important not to confuse sensitivity analysis and scenario analysis. Here are some key differences to look out for:
Financial sensitivity analysis is mainly used to understand the effect the independent variables on some demand variables.
Financial sensitivity Analysis is utilized to understand the impact of an arrangement of independent factors on some dependent variables under certain particular conditions. For instance, what would the effect be to your gross margin, if a new competitor entered your market and pushed the overall product prices down? Financial sensitivity analysis isolates these variables and then records the range of possible outcomes. Helping the analyst or an investor to evaluate business risk, needs and future outcomes.
On the other hand, scenario analysis requires the financial analyst to describe a particular scenario in detail. After specifying the details of the scenario, the analyst would then have to specify all the variables within the scenario so that they align with it. The result is a very comprehensive picture of the scenario. The analyst or an investor would know the full range of outcomes.
As many financial plans and models are still created in Excel utilising advance sensitivity analysis might be difficult. A data table can be an effective way to present such valuable financial information to a boss or a client, but due to its complexity, it might lead to some confusion. Using a system for operations like this you could save hours of time instead of trying to reason with Excel document! There are many around but have a look at ProForecast and advanced scenario and sensitivity planning tools we offer.
There is no reason to ignore sensitivity analysis for your business, as it is still used by many corporate investors and shareholders. Also, being aware of the potential risks to your business will make you very aware of the decisions you are making.