Scenario Analysis provides valuable insight into the course of business. It is a financial model that has input parameters that are to be set and the output parameters that gives the results according to the inputs given.
What translates the input into the output is the particular financial model of that particular business. Businesses have things in common to obviously these financial models also have similarity.
It is called a ” scenario analysis ” because multiple inputs change simultaneously depicting a scenario that yields outcomes represented by output results for the given set of inputs.
When Should You Perform Scenario Analysis?
Scenario analysis can be effected only on a fully functioning model that does not have any glitches. So Scenario Analysis is performed only after such a model is developed or made available.
How is Scenario Analysis Performed?
Every scenario is a combination of the different values of the input parameters (that yields the results).
Thus scenario analysis is generally performed in 2 ways-
1. Say for example 3 sets of inputs are fixed and termed as bad case, worse case and worst case. The user has to select any one and h/she will get the output. This is meant for people without in-depth knowledge of finance or management.
2. The second way is for experts/ seasoned professionals who have detailed knowledge of finance and management – the user is enabled to vary each and every parameter individually and obtain results.
In both these cases a document stating the implications and assumptions of each and every parameter and their variation is provided.
Shortcomings of Scenario Analysis
- Analysis Paralysis: Scenario analysis is data fed so taking too much time to gather data might lead the model to depict a situation that is not relevant anymore.
- Inability to Predict Growth Drivers: Non-financial factors cannot be incorporated into SA. For example technological innovation that will help capture market.
The bottom line is that scenario analysis is an useful tool that provides insight into various circumstances but it does have its shortcomings. However, an able executioner should be able to implement the scenario analysis tool too good effect.