Scenario Analysis vs. Sensitivity Analysis

As we all know, scenario analysis and sensitivity analysis are two essential methods used by financial professionals for forecasting and planning. Today, we will dive deeper into these methods and provide examples of the most popular scenarios and sensitivities employed by CFOs and FP&A analysts.

Sensitivity analysis is a technique that evaluates the effect of a single variable on the output of a financial model or budget. It tells us how much one variable can change before it affects the results of our financial projections adversely. It's an essential tool for identifying which variables have the most significant impact on the model and prioritizing them to mitigate risk.

Here are the top 5 examples of sensitivity analysis used by financial professionals

1. ‍Interest rate sensitivity: This analysis examines how changes in interest rates can impact the company's bottom line. It's critical for companies with debt as a sudden increase in interest rates could significantly increase their expenses.
2. ‍Sales volume sensitivity: This analysis examines how changes in sales volume affect the company's results. It's crucial for businesses with a sales-driven model and helps them predict possible outcomes if their sales decrease.
3. ‍Cost sensitivity: This analysis examines how changes in costs affect the profitability of a project. Businesses need to identify and mitigate any cost risks before they can lead to financial loss.
4. ‍Currency sensitivity: This analysis examines how fluctuations in the foreign exchange market can impact the company's profits. Companies with significant foreign transactions must keep in view currency risks.
5. ‍Inflation sensitivity: This analysis examines how inflation can impact a company's performance. Businesses need to ensure their profits remain stable in high-inflation environments.

Scenario analysis is a technique that examines the outcomes of different scenarios to help companies understand how they can affect their performance. It considers multiple variables and provides a range of potential outcomes based on various assumptions.

Here are the top five examples of scenario analysis used by financial professionals

1. Best-case scenario analysis: This analysis examines the most favorable financial outcome for the company if everything goes according to plan. Useful for decision-making, project management, and target-setting.
2. ‍Worst-case scenario analysis: This analysis examines the potential financial outcome of a project if the worst-case scenario happens. Companies must identify potential risks that could lead to financial loss.
3. ‍Strategic scenario analysis: This analysis examines the potential outcomes of different strategic decisions. It's useful for evaluating new projects, entering new markets, or making significant investments. Examining how different scenarios may impact the company's finances, helps decision-makers make informed choices on whether a proposal is viable or not. For example, a company considering expanding into a new market can evaluate the potential risks of foreign competition, regulations, and other factors that could impact the project's success. Through scenario analysis, they can identify the best course of action for the company.
4. Sensitivity scenario analysis: This is a technique used to evaluate how changes in specific variables can impact outcomes or results. This analysis involves testing different scenarios by making adjustments to one or more input variables to determine how each scenario can affect the overall result.
5. Black swan scenario analysis: This analysis examines the outcome of rare and unpredictable events that have a significant impact on the company's performance. Companies need to consider potential worst-case scenarios that might occur but are unlikely to happen to prepare themselves for any unseen risks in the future. The COVID-19 pandemic can serve as an example of a black swan event that has altered plans for businesses around the world.

‍