What is Scenario Analysis and sensitive analysis?

Scenario Analysis is a financial process through which investors & business managers can determine the amount of risk they are taking before making the investment or starting a new project. It is a way of structured thinking in which the earnings or value impact is computed for different interest rate scenario that may seem relatively unlikely but could pose serious risks if those scenarios show up. Thus, the scenario analysis helps identify potential future problems, and take necessary precautions to eliminate the problems or reduce the impact of these problems.

Scenario analysis typically involves considering at least three types of scenarios:
Base-case scenario: A baseline scenario based on current assumptions
Worst-case scenario: The most negative set of assumptions
Best-case scenario: The ideal projected scenario to achieve goals and objectives

In the business environment, fluctuations are largely based on external factors like the change in demand for a company’s product or new regulations of the Government that may impact on the profitability of the project etc. In a sensitivity analysis (also known as a what-if analysis), possibilities of such unfavorable changes are accounted to find out the impact of such changes on the profitability of the project by tweaking one key input or driver in a financial model, and seeing how sensitive the model is to the change in that variable. Sensitive analysis involves identification of the sensitive variables such as demands, expenses, operating costs and legal costs, sales, costs, profit etc. This method of changing the value of those sensitive variables and observe the effects of changes on the revenues is known as sensitivity analysis.

Scenario analysis is a forward-looking technique that can be used to:
Identify risks
Scenario analysis can help identify and measure the potential for operational risk events, such as natural disasters or terrorism.
Make decisions
Scenario analysis can help businesses and individuals make decisions by anticipating potential profits and losses.
Plan for the future
Scenario analysis can help businesses plan for the future by analyzing the impact of potential events and strategic decisions.
Inform stakeholders
Scenario analysis can help companies inform stakeholders of their financial health and valuation.