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How Sensitive Should Your Sensitivity Analysis Be?

July 11, 2016

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Our last blog “The Power of the What-If Analysis”, outlined what a business would look like in a variety of scenarios, including the good, the bad and the ugly. The next question is – what should be considered “good” and what should be considered “ugly”?

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Every business is unique and multiple variables will factor into forecasting future operating results; a “good” scenario in one company may translate to a “bad” scenario for another. For example, a 10% increase in revenues for Company A may be considered a good year. However, if Company B has experienced 20% revenue growth in the past, a 10% increase in the current year indicates that their growth is slowing down and the business may not be able to operate like it has in the past.

When preparing scenario analyses for forecast models, it is always useful to consider what the operational results have been historically because these results provide a good indicator or, at the very least, a baseline of what is to come in the future (assuming the business is not going into a downturn cycle). Of course, the forecast should also take into consideration industry and market conditions to properly reflect an achievable result in the forecasted years. The forecast would not be very useful if business operations are projected to grow by 50% when in reality industry and markets are slowing to a halt.

With that said, a sensitivity factor is applied in a forecast and is up to the discretion of the financial model preparer. Although the forecast should reflect a realistic projection, the preparer may include extreme results in order to test what would happen in a worst-case scenario. For example, the preparer could forecast if there is enough cash in a company to weather a storm.

We recommend forecasts to reflect the realistic scenarios, but in the analysis extreme results should be considered so a business owner is sufficiently prepared if a worst case scenario occurred.

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