Financial Modeling

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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.

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