
Do you want to enhance your company’s financial performance and make smarter predictions?
Although forecasting the future may be tough, employing financial analytics like sensitivity analysis can provide insights into the factors affecting your business operations and aid in making informed decisions.
Ready to learn more about sensitivity analysis?
Understanding Sensitivity Analysis
Sensitivity analysis is a technique used in financial modeling that helps determine how different independent variables impact the outcome of a model. These variables include factors such as:
- Units sold
- Customer traffic
- Costs
- Revenues
- Interest rates
- Loan repayment periods
- Tax rates
By changing the value of an independent variable within a sensitivity analysis model, you can determine its impact in a given situation.
For instance, by adjusting the values of interest rates and monthly payments, a company can accurately determine the loan repayment period and choose the most affordable option.
Another example where sensitivity analysis proves valuable is in the context of discounted cash flow (DCF) analysis. Here, it helps evaluate how changes in key variables—such as growth rates, discount rates, and cash flow projections—impact the results of your DCF model.
Sensitivity analysis can help companies understand how various independent factors influence and impact one another. It can identify opportunities, help make accurate financial predictions, reduce future risk and much more.
Why is Sensitivity Analysis Important?
Sensitivity analysis is key to understanding the opportunities and risks in your company’s financial decisions, while also enabling data-driven predictions. It is essential to help companies:
- Identify Impactful Factors. Sensitivity analysis helps determine which variables have the most significant impact in a given situation.
- Strengthen Decision-Making. By using historical data to test scenarios, your company can make informed decisions for potential future financial situations.
- Assess and Manage Risks. Financial analysis helps businesses assess potential future risks. This can be done through a sensitivity analysis spreadsheet, which allows companies to evaluate potential outcomes and forecast cash flow, ROI, project feasibility, and more.
- Allocate Resources Efficiently. Sensitivity analysis can help your company budget efficiently by identifying where to allocate resources, which projects need more funding, and areas where costs can be reduced.
How to Conduct a Sensitivity Analysis
The simplest way to conduct a sensitivity analysis is to adjust one input variable at a time while keeping all other variables constant. This isolates key variables and shows their impact on the output.
When conducting a sensitivity analysis, you’ll first need to identify key variables. These are the factors you expect will have an impact on the final output.
For example, a clothing store wants to understand how customer traffic impacts total revenue. The variables at play are number of customers, sales and revenue.
Next, determine a realistic range of values for the independent variables.
The clothing store looks at its historical data and determines its typical range of daily customers, transactions and average sales numbers.
Using a spreadsheet, change the input variables within that range to observe, analyze and understand how they affect the output.
The clothing store finds that a 10% increase in customer traffic leads to a 5% increase in transaction volume. Using these numbers, the store can then estimate how much revenue would be gained from different increases in customer traffic.
Typically, multiple analyses are conducted to get a full picture of all variables and their impact on the final output—in this case, total revenue.
What are the Challenges of Sensitivity Analysis?
There’s no doubt that sensitivity analysis can be a valuable tool to help your business. However, it is important to be aware of some of the challenges and limitations it can have:
- Data Accuracy. For accurate sensitivity analysis, use precise historical data. Ensure your financial data is up-to-date, reliable and easily accessible by investing in digital accounting and data management systems, or by outsourcing your bookkeeping to the experts.
- Analysis Complexity. Financial models should strike a balance between simplicity and complexity. An overly simplistic analysis may lead to incomplete conclusions, while an overly complex one can complicate decisions and add unnecessary stress.
- Predictions May Not Come True. Sensitivity analysis relies on past company data. While using real numbers is the most accurate way to make business decisions, it’s important to remember that financial analysis can never fully predict the future. Unexpected events can and will occur to any company.
The Benefits of Outsourcing Sensitivity Analysis
If you’re not an expert in finance, sensitivity analysis and other financial analytics can be tricky to understand and conduct accurately. That’s why we recommend outsourcing your finances to trusted financial experts.
Our team at Finvisor has over a decade of experience helping startups and small businesses with accounting, CFO support, financial reporting and other back-office needs.
We can provide your organization with accurate financial analysis, including sensitivity analysis and DCF analysis, using the right tools to streamline your decision-making process.
To see how our team can help your startup or small business with sensitivity analysis and other financial analysis tasks, contact us today.
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