Scenario analysis is intrinsically linked to a business’s finances because it is a way to learn how decisions impact a business. Additionally, a scenario analysis report may also show that a project is underfunded, and in this case, increasing the capital investment may be necessary.
Decision-making, using scenarios, is one way to control a business’s financial health using a data-driven approach.
How Does Scenario Analysis in Financial Modeling Work?
Multiple types of scenario analysis exist, but they are all very similar. When you remove the figures and different variables, a scenario is a forecast of what can happen when a variable is adjusted.
For example, if you hire a new employee, what will happen?
A financial projection example will require you to use analysis to learn the outcome of your decisions. Perhaps hiring an employee means that you’ll:
· Increase production by 10%
· Earn 10% higher profits
· Spend $75,000 on hiring and training costs
However, the scenario can change with inputs, such as what happens if the employee quits? What happens if sales slump during the specific time period? And so on.
Many businesses will run scenarios when new products are introduced. The scenario may account for:
· What happens if 10,000 products sell?
· What happens if 100 products sell?
Based on this information, you may want to go a step further. If the product oversells, what do you need to do to keep the business running? Perhaps one scenario includes hiring three new employees to ensure production runs smoothly and orders can be fulfilled.
Scenario analysis risk management is a major part of business and a reason that companies create financial forecast scenarios. Every business decision comes with its own set of risks, and scenario analysis allows you to do your best to account for these risks and create a plan to overcome them.
Often, multiple scenarios are made to account for best-case and worst-case scenarios.
Businesses will try to account for every scenario, but there will always be times when something unexpected occurs.
How Is It Possible to Prepare for Every Scenario?
Scenario analysis tools make it possible to prepare for every known scenario. The key most important thing is to include all of the interconnected factors in your business when building scenarios.
When you look at everything in your business, you can determine the best, worst and most likely outcomes.
Scenario analysis should also allow you to test multiple inputs at the same time to get more accurate results.
How Can Financial Analysts Improve Their Scenario Analysis?
There are several things financial analysts can do to improve their scenario analysis.
Allow for Many Variables
A scenario analysis should allow for many variables because the future is uncertain. Make sure that you can enable as many assumptions as possible at once to see how your business may be impacted by different changes, such as:
· The cost of goods or materials
· Debt interest
Allowing for many variables will help you better prepare for virtually any situation.
Make Your Model Dynamic
Financial models should be structured in a way that allows data to be updated quickly and easily. Operations and market changes can happen at any time. Dynamic financial models make it easy to adjust to these changes as they occur.
Taking the dynamic approach means that you can adjust a scenario with the click of a button.
Organize All Scenarios
At the very least, you should have a best, worst and most likely case when performing scenario analysis. Ideally, it would be best if you had a range of scenarios that consider multiple variables to help your business prepare for any outcome.
It’s important to keep these scenarios organized and displayed in a way that non-finance leaders can understand.
Keep the Future in Mind
Scenario analysis and planning should always be performed with the future in mind. Always account for anticipated or expected industry changes when engaging in scenario analysis.
Mistakes In Financial Modeling Scenario Analysis
Traditionally, financial modeling scenario analysis has been a tedious and time-consuming process. Automated tools can save time, but there are still some mistakes that should be avoided, such as:
· Using static models. Updates to state models must be done manually, which requires a great deal of time and can increase the risk of errors.
· Linking multiple spreadsheets together. Linking hundreds of spreadsheets can increase the risk of mistakes and lead to confusion.
Using automated tools can help prevent some of these mistakes, reducing the risk of errors and saving time in the process.
Scenario analysis planning plays a vital role in financial projection. Use this guide to improve your analysis and avoid making mistakes.