Sensitivity Analysis

What is Sensitivity Analysis?

• Sensitivity analysis is a technique which allows the analysis of changes in assumptions used in forecasts

Assumptions are used in many different types of business forecasts:

• Cash-flow forecast:

  • Timing of cash inflows and outflows

  • Amount of cash inflows and outflows

  • Receivables and payables days

• Budgeted profit:

  • Sales volumes and unit selling prices

  • Gross profit margins and overheads

• Investment appraisal:

  • Timing and amount of project will run

  • The period over which the project will run

  • Amount of initial investment

• Breakeven analysis:

  • Average selling prices and variable costs

  • Fixed costs by category and total

Key questions to ask in business forecasts:

• How reliable are the assumptions made?

• What happens if assumptions turn out to be significantly different in reality?

• Which assumptions are most significant to the forecast?

Sensitivity analysis ‘what-if?’:

• Allows key assumptions to be changed to analyse the effect

• Helps judge the degree of risk (e.g. in an investment project)

• Recognises that there is no such thing as an accurate forecast

• Considers one variable or assumption at a time

Results of the sensitivity analysis:

• Allows key assumptions to be changed to analyse the effect

• Helps judge the degree of risk (e.g. in an investment project)

• Recognises that there is no such thing as an accurate forecast

• Considers one variable or assumption at a time

Benefits of sensitivity analysis:

• Identifies the most significant assumptions (which therefore require closer attention)

• Helps assess risk and prepare for a less-than-favourable scenario

• Helps make the process of business forecasting more robust

Drawbacks of sensitivity analysis:

• Only tests one assumption at a time (many assumptions may be linked)

• Only as good as the data on which forecasts are based

• A somewhat complicated concept - not understood by all managers