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What is “Scenario and Sensitivity Analysis”?

Scenario and sensitivity analysis helps a financial modeler to understand the major drivers of a project or business. In addition to this, one needs to understand the project or business’s capability of withstanding various scenarios, such as a downturn in the economy. Recent economic activity has shown that these changes can happen suddenly and drastically, which is why scenario analysis is more important than ever.

With this in mind, one might even ask the question of why we need to also flex individual variables in a financial model if variables are unlikely to move independently? The answer lies in understanding what drives a business or project and is key for negotiations when it comes to financing and financial decisions.

Key Learning Points:

  • Scenario and sensitivity analysis allows investors to look at the key drivers of a company and the impact of any potential changes, both positive and negative.
  • Changes can be wide-ranging: broad issues such as macro, economic and political or more company specific and related to the underlying business.
  • Scenario analysis – looks at how a changing macroeconomic landscape can impact a company or operation.
  • Sensitivity analysis – this is most useful for discovering which financial inputs a business is most sensitive to.

What is Scenario Analysis?

In the real world, it is unlikely that single “inputs” to a business or project move independently. Indeed, economics (and economic policy) generally dictates that variables move in some coordinated fashion. For example, a change in interest rates is likely to coincide or even cause a shift in exchange rates. Higher interest rates, after all, are attractive to foreign investors and may cause capital inflows to a country, which in turn will drive exchange rates up.

Scenario analysis in financial modeling involves changing multiple variables concurrently and assessing the impact on a financial model. A key issue can be calculating if a business will be able to service its debt if there is a change in the economic environment in which they operate. Some of the variables that may be stressed simultaneously in a scenario analysis include:

  • Exchange rates
  • Interest rates
  • Inflation
  • Project availability for project finance
  • Resource availability for renewable energy deals
  • Sales and other revenue drivers
  • Expenses and the growth rate of expenses

“Monte Carlo Analysis” is a common form of scenario analysis and is often used for stress testing large projects, and stresses a range of inputs according to some statistical distribution. The outputs are also recorded to provide a range of likely outcomes.

Many lenders to businesses will want to know what scenarios may lead a business or project to default on its debt. While scenario analysis seems as simple as changing some input variables, there are some complications such as keeping debt repayment schedules fixed or hardcoded where required – as is often the case in project finance. This is also common in deals where debt repayment is initially calculated on a sculpted basis, but once financing is provided the repayment schedule is fixed. Allowing a debt schedule to be sculpted or changed according to a new scenario may result in debt not amortizing in the required time.

Sensitivity Analysis (or Knowing What is Non-Negotiable)

While there are individual variables that may change independently (a risk for renewable energy developers is the lack of resources – a cloudy day can mean no revenue for a solar business), sensitivity analysis is most useful to understand which of the financial model inputs the business is most responsive to. These are the inputs where unexpected changes can suddenly and drastically impact a business’ performance.

Understanding these variables not only helps management to know what to pay close attention to, but also it can help improve negotiations with suppliers and financiers. For example, if a supplier is wanting to either increase the price of service A or service B to a company, the company may be willing to allow a price increase on service A if it does not substantially affect the company’s profitability, while keeping the price of service B stable which has a larger proportional impact on profits.

Why Do We Need Both Sensitivity and Scenario Analysis?

A financial model will generally include a specific worksheet outlining the inputs and results of sensitivity and scenario analysis. Although technically different, they are sometimes grouped under the term ‘Scenario Analysis’. The wording of the scenarios will indicate whether the scenario is indeed a scenario, or simply a sensitivity analysis or single variable change.

For example, the term ‘Downside Scenario’ may show the result of a 10% revenue decrease and a 10% cost increase as well as some other change. The term ‘Revenue Down’, however, will only show the output of decreasing the revenue by 10%. An experienced financial modeler will be able to advise on where these two tools are used and how to implement them in a financial model.