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Scenario Analysis
After successfully creating a financial model, it is essential first to analyze then make a decision. The process is called scenario analysis. Scenario Analysis is also known as “What-if” Analysis. It can help you to gain better confidence in projections.Scenarios are feasible combinations of parameters:
- Best case – Highest sales prices + lowest costs (only one possibility)
- Worst case – Lowest selling price + highest costs (only one possibility)
- Most-likely case – Most likely combination of prices and costs
Common Uses of Scenarios –
- Allow for sensitivities analysis
- Able to better answer “What if” questions
- Gain better confidence in projections
- Varying levels of operating performance
- Range of synergy realization
- Multiple target analysis in Mergers and Acquisitions (M&A) situations
- Stress test for loan structuring and covenants
Various Sources for Scenarios –
- Management forecasts
- Internal budget or forecasts
- “Outlook section” in the MD&A
- Research expectations
- Based on historical performance
One should always play around with assumptions to see if they make sense in all cases. The assumptions must be reasonable and defensible.
