Always Be Prepared: Your Business Needs a Sensitivity Analysis - Now
The worst time to start planning for a crisis is when one is actually happening. A little foresight can mitigate the damage caused by economic turbulence, especially if companies use the right analytical tools.
One such tool is a sensitivity analysis, also called a “what if” analysis.
A sensitivity analysis predicts the outcome of a decision under different assumptions. “Sensitivity analysis is a powerful and illuminating methodology,” writes University of Western Australia agriculture professor David J. Pannell. It “can be easy to do, easy to understand, and easy to communicate. It is possibly the most useful and most widely used technique available to modelers who wish to support decision makers.”
Researchers, analysts, scientists, and investors use sensitivity analyses to manage risk. By the same token, entrepreneurs and business owners can use this effective tool to examine scenarios affecting their companies’ most important drivers. A sensitivity analysis will highlight the financial impact on earnings, capital requirements, financial returns, etc. that result from changes in business assumptions.
Managers should begin the sensitivity analysis by identifying their key business drivers. For example: Realtors may watch price per square foot; manufacturers monitor the cost of raw materials; media companies scrutinize advertising trends.
A sensitivity analysis should then be applied to each key business driver. This will help companies anticipate future needs for operating cash, particularly in the event of a significant downturn. Executives should be equally prepared for upside opportunities so they can take full advantage of them. The main benefit of a sensitivity analysis is the ability to prepare for a variety of different scenarios.
For example, an export company needs to monitor currency fluctuations. Its managers should do a what-if analysis of various foreign exchange rate scenarios, “bookending” good and bad extremes. They might ask, “If the dollar depreciates 20 percent against the currency of our major export market, what’s going to happen to our customer base?” It will make our goods cheaper in the foreign country and thus increase sales. The company can then determine what options it has to meet the increased demand. It would also want to do the same analysis on the financial impact of the dollar going up, which would make its products less affordable abroad and thus decrease sales.
Executives would also be wise to conduct a sensitivity analysis when launching a new product or undertaking an expansion. They might ask if their new venture can survive if sales don’t meet some percent of expected targets.
When the worst-case scenario is very bad and the best-case scenario is very good, the project is high risk and having a good sensitivity analysis will help the company prepare for the worst while planning for the best.
Get Started Spend time now to establish what-if scenarios and create a model to help you understand the implications of changing assumptions to your business. Create them before a crisis arrives. Initially your model should be simple and easy to understand. This will help you and your staff develop comfort in how to use it and prevent the dreaded “ paralysis by analysis”. As your team becomes more familiar with how to use the model you can make it more complex.
When sensitivity analyses are properly constructed and managed, executives are well prepared to meet future challenges.
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