Scenario Analysis: A Primer

Scenario analysis is at the heart of financial modeling. In fact, in many cases, a financial model is created solely so that the management is able to conduct scenario analysis before they can arrive at a decision. This article will provide more information about scenario analysis and its application in the financial modeling domain.

What is Scenario Analysis?

A financial model is nothing but a collection of inputs and outputs. If the inputs to the model are changes, the output to the model changes by default! This process of changing inputs and checking how the business would perform under different situations is called a scenario analysis.

Financial modelers usually provide the ability to change a single input at a time. This is done in order to allow the financial modeler to isolate the effects of that single input. However, in reality, inputs do not change in isolation. Inputs change in correlation with other inputs. For instance, an increase in interest rates is often accompanied by fewer sales and more bad debts. This combination of inputs which occur simultaneously is called a scenario.

A good financial model allows simulations and scenario analysis to be easily performed. This is because a good financial model requires the user to enter inputs only once. Hence, by varying the inputs at that one location, scenario analysis can be performed. If the inputs have to be entered at multiple places, it is quite possible that the user may forget to enter the input at different locations within the model and as a result, the model may end up giving less than optimal results.

When Should You Perform Scenario Analysis?

Scenario analysis needs to be performed only after the model has been completed. This is because the model needs to be tested for accuracy and consistency under normal circumstances before it can be assigned the complicated task of projecting the effect of different scenarios on financial statements.

How is Scenario Analysis Performed?

Each scenario has assumptions. Some of the assumptions are explicit, whereas other assumptions are implicit. It is the job of a financial modeler to ensure that the end-user is made fully aware of all the assumptions in the model. This is the reason why most financial models have two modes.

  1. One mode allows the user to choose a pre-defined scenario. Here, the user cannot edit individual inputs. They can only choose the scenario type like the best case, worst case, or most likely scenario. Once the user chooses the scenario, the inputs to the model are automatically filled in. Also, there is usually a separate worksheet where documentation is provided regarding the nature of the assumptions. This saves the user’s time since they do not have to enter inputs manually. Also, this makes it possible to draw standard-reports easily. The standard model is for users who are not experts. It prevents them from entering inputs which are inconsistent and drawing invalid conclusions.

  2. The second mode, which is commonly referred to as an “Expert mode,” is where the model allows users to change individual assumptions. For instance, the user can select one of the above-mentioned scenarios as the base case. They can then vary individual inputs in the base case to see its impact on the financial model.

It is the job of the financial modeler to ensure that the layout of the results of scenario analysis is similar. This is essential to ensure continuity and consistency for the end-user.

Shortcomings of Scenario Analysis

  • Analysis Paralysis: Scenario analysis is a good tool for obtaining quick references while making decisions regarding the business. However, in many companies, there is an extreme emphasis on data. This often leads to an analysis paralysis wherein companies are not able to act because they spend too much of their time and resources collecting data. It needs to be understood that any action needs to be taken swiftly. This is because the market is moving extremely quickly, and companies which take too long to respond are often left behind. Also, business users should keep in mind that the financial models created are a part of a make-believe process. The results provided are close estimates at best and by no means, perfect!

  • Inability to Predict Growth Drivers: Also, it needs to be understood that the future of a business or an industry cannot be guessed in purely financial terms. Looking at the different financial figures over and over again distracts companies from underlying technological changes which may actually be driving growth in the industry.

    For instance, no amount of financial modeling by Nokia would have helped the company identify the challenge it is likely to face from the Apple iPhone. In most industries, growth is driven by technological innovation which makes it possible to create a better product or to create the same product more cheaply. This cannot be done via scenario analysis.

The bottom line is that scenario analysis is an extremely valuable tool. It can help the company understand and predict a wide range of circumstances and be prepared for them. However, it should not be considered infallible. Scenario analysis also has a few shortcomings. The financial modeler must be aware of these shortcomings as well.

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