Financial projections show a single outcome 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 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.
With sensitivity analysis only one input is changed at a time in order to assess the impact of that input on the financial projection. By changing each input seperately it is possible to assess the significance of each variable on the business
Scenario Analysis and Sensitivity Analysis in a Business Plan
One way a business can demonstrate the effect of changes in inputs in a financial projection is to provide three different scenarios, so that the financial risk of the business can be simulated under different conditions.
The difference between sensitivity analysis and scenario analysis is that sensitivity analysis changes only one input at a time in order to assess the sensitivity of the financial projection to that variable. With scenario analysis, all inputs changes are made at the same time with the purpose of assessing the effect on the business plan of a complete change in circumstances.
The three main scenarios are usually referred to as the best case, base case and worst case scenarios and the procedure for carrying out the analysis using the financial projections template is as follows:
Step 1 – Develop the Base Case Scenario
The base case scenario in the sensitivity analysis is the financial projection which represents the outcome which is most likely to happen. This is your financial forecast, based on what you know, it is what you feel the outcome will be.
Step 2 – Develop the Best Case Scenario
Make a copy of the base case scenario financial projections template developed in step 1, and amend the inputs to show what will happen if your positive expectations are met, and you can seize all the opportunities available to the business.
For example, in the base case scenario, you might estimate that revenue will increase by 5% each year, in the best case scenario, you might want to show what will happen if revenue increases by 10% each year. When carrying out sensitivity analysis, it is important to remember that the projections still have to be feasible and achievable, they are not simply hypothetical what ifs.
Step 3 – Develop the Worst Case Scenario
Again, make a copy of the base case scenario financial projections template developed in step 1, and change the inputs to reflect what will happen if your negative expectations are met, if all the problems anticipated do happen, and projections develop worse than expected.
For example, in the base case scenario, you might have anticipated opening an export market in year three, show what will happen if that market does not develop or is delayed until a later year.
Investors will look at the sensitivity analysis and in particular the worst case scenario, to see how vulnerable the business is to assumption and input changes in order to assess the risks involved in the business.
When presenting the best case, worst case, and base case scenarios a brief description should be provided to show how the major assumptions and inputs have been changed between scenarios. In addition, for the base case scenario a detailed description should be given, and for the best and worse case scenarios, a summary of the key financial information should be provided.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.