What is Scenario Analysis?
Scenario analysis is a process of examining and evaluating possible events or scenarios that could take place in the future and predicting the various feasible results or potential outcomes. In financial modelling, the process is typically used to estimate changes in the value of a business or cash flow, significantly when potentially favourable and unfavourable events could impact the company.
Most business managers use scenario analysis during their decision-making process to find out the best-case scenario and worst-case scenario while anticipating profits or potential losses. Individuals can use this process when they have a significant investment, such as purchasing a house or setting up a business. This guide will help you understand why scenario analysis is essential and how to perform it yourself.
Generating Cases to be Used in Scenario Analysis?
When performing the analysis, managers and executives at a company generate different future states of the business, the industry, and the economy. These future states will form discrete scenarios that include assumptions such as product prices, customer metrics, operating costs, inflation, interest rates, and other business drivers.
Managers typically start with three basic scenarios:
Base case scenario – It is the average scenario based on management assumptions. For example, when calculating the net present value, the rates most likely to be used are the discount rate, cash flow growth rate, or tax rate.
Worst case scenario – Considers the most severe outcome in a given situation. For example, when calculating the net present value, one would take the highest possible discount rate and subtract the potential cash flow growth rate or the highest expected tax rate.
Best case scenario – It is the ideal projected scenario and is almost always put into action by management to achieve their objectives. When calculating the net present value, use the lowest possible discount rate, the highest possible growth rate, and the lowest possible tax rate.
What are the Benefits of Performing Scenario Analysis?
There are many reasons why managers and investors perform this type of analysis. Predicting the future is an inherently risky business, so it’s prudent to explore as many different cases of what could happen as is reasonably possible.
Key benefits include:
Future planning – gives investors a peek into the expected returns and risks involved when planning for future investments. The goal of any business venture is to increase revenue over time, and it is best to use predictive analysis when deciding to include an investment in a portfolio.
Proactive – Companies can avoid or decrease potential losses resulting from uncontrollable factors by aggressively preventing worst-case scenarios by analysing events and situations that may lead to unfavourable outcomes. As the saying goes, it is better to be proactive than reactive when a problem arises.
Avoiding risk and failure – To avoid poor investment decisions, scenario analysis enables businesses or independent investors to assess investment prospects. Scenario analysis takes the best and worst probabilities into account so that investors can make an informed decision.
Projecting investment returns or losses – The analysis uses tools to calculate the values or figures of potential gains or losses from an investment. This gives concrete, measurable data that investors can base their approaches on for (hopefully) a better outcome.
What are the Drawbacks of Scenario Analysis?
Requires a high level of skill – Scenario analysis tends to be a demanding and time-consuming process that requires high-level skills and expertise.
Unforeseen outcomes – Due to the difficulty in forecasting what may occur in the future, the actual outcome may be entirely unexpected and not foreseen in the financial modelling.
Cannot model every scenario – It may be challenging to envision all possible scenarios and assign probabilities. Investors must understand that there are risk factors associated with the outcomes, and they must consider a certain amount of risk tolerance to attain the desired goal.