In: Finance
As you consider scenario analyses, how do you ascertain the types of situations you would want to evaluate?
Scenario analyses is essentially a process of determining the possible events which could have a significant impact on the outcome one is analysing. To ascertain the types of situation one would like to evaluate, one should consider the alternatives in the context of the end objective of the scenario analysis.
For instance, in financial modeling, scenario analysis is typically used to estimate the impact on the valuation of the business. Thus, the types of scenarios one can take in to account are
Base Case: if status quo is maintained (events turn out to be as expected.i.e. the management assumptions about sales growth, margins and the other business elements are correct)
Worst Case: to evaluate the impact of unfavourable events (prices are low, volumes are low, margins are shrinked and profitability eroded)
Best Case: to evaluate the impact of favourable events (demand increases and thus the prices also increase, volumes are high, margins are also increased due to pricing power and profitability increases)
Now, consider the case where the manager would like to chalk out a contingency plan to maintain business solvency in case of an accepted proposal not working out as expected in the future. Based on the output of the scenarios, the manager would like to maintain a cash reserve as a cushion. In this case, the manager would consider two scenarios, one is the impact is unfavourable and another could be an extreme case wherein the project is shut.
Thus, the types of situations to be considered is based on the
objective of the analysis.