Question

What is scenario analysis? Differentiate between sensitivity analysis and scenario analysis. What advantage does scenario analysis have over sensitivity analysis? Why is it important to conduct risk analysis? In which situations do you think it would be beneficial or not.

Answer 1

Scenario analysis and sensitivity analysis are integral part of financial modelling but are really slight variations of the same thing. Sensitivity Analysis is a process where we try to determine the sensitivity of a financial projection by changing one input. The idea is to change the input variable and then assess the impact. On the other hand, Scenario Analysis is a process where various (more than one) input changes are made at the same time with the purpose of assessing the effect on the business plan in case of a complete change in circumstances. Example of Senstivity Analysis are: Effect on Gross Margin of a project as a result of changes in sales, costs, etc. Example of Scenario Analysis: "If my costs turn out x% higher than expected, then I will raise my selling price by y%, but that means I will sell z% less, so what is the NPV going to be under these circumstances?”. The effect of changes in inputs in a financial projection to provide three different scenarios, so that the financial risk of the business can be simulated under different conditions. The three main scenarios are usually referred to as the Base case, Best case, and Worst case scenarios

Sensitivity analysis is used to understand the effect of a set of independent variables on some dependent variable. On the other hand, scenario analysis would require the financial analyst to describe a specific scenario in detail.

It’s imperative to conduct risk analysis as Financial projections show a single outcome only based on a set of assumptions and inputs. Uncertainty in the various assumptions and inputs creates risk, and will determine how the investor interprets the projections. Sensitivity analysis and Scenario Analysis is carried out in order to assess risk. For example, an investor might want to know what happens if revenue targets are not met and the likely impact of using an alternative revenue target, or a lender might want to assess the effect of changes in interest rates on the financial projection. Such an exercise would involve examining the sensitivity of the financial projections to changes in its assumptions and inputs.