Sensitivity Analysis: “What if” Analysis
A financial model is a great way to assess the performance of a business on both a historical and projected basis. It provides a way for the analyst to organize a businessâs operations and analyze the results in both a “time-series” format (measuring the companyâs performance against itself over time) and a “cross-sectional” format (measuring the companyâs performance against industry peers).
Typically, once an analyst inputs both historical financial results and assumptions about future performance, he/she can then calculate and interpret various ratio analyses, and other operational performance metrics such as profit margins, inventory turnover, cash collections, leverage and interest coverage ratios, among others.
General Rule of Thumb in Sensitivity Analysis
A scenario manager allows the analyst to âstress-testâ the financial results because the reality is that expectations can and usually do change over time.
In previous articles, we discussed the fact that these forward-looking assumptions may not always hold true, and that the use of a scenario manager is a great way to incorporate several performance possibilities into your financial model. This allows the analyst to âstress-testâ the financial results because the reality is that expectations can and often do change over time. Because the future cannot be predicted with any certainty, it’s never a good idea to take your financial modelâs results and claim, either to your boss or to your client, that the results are final.
So what can you do if the financial modelâs results are not the final results? Isnât that why you build a model in the first place â to get some clarity or answer as to the future performance of the business? Yes and no. The purpose of the financial model is to provide some insight into future performance, but there is no one correct answer. Clients and managing directors like to see a range of possible outcomes, and this is where the sensitivity analysis, or âwhat-ifâ analysis comes into play.