Mastering Scenario Analysis for Smarter Financial Modeling

Scenario analysis is simply a method of determining a future outcome based on one or more variables. It’s especially important in financial modeling, when many different variables can determine the overall financial results. For this reason, many startups will run a variety of different scenarios to help them understand potential outcomes. For example, it’s often suggested that startups run scenarios when financial modeling to determine a best-case, worst-case and most likely outcome.

The better the scenario analysis, the more accurate your modeling is likely to be. The more accurate your modeling is, the better you’re able to make decisions to shape the future of your startup’s financial health.

What is Scenario Analysis?

Scenario analysis is a process that aims to examine future events and their impact on an outcome. It can help a startup better anticipate change, prepare for certain events and, ultimately, create more effective strategies to meet any pre-determined goals.

Scenario analysis also plays a significant role in financial modeling. At the individual level, people can run various scenarios to predict the future value of an investment and then have a better understanding of what needs to happen to meet any specific investment goals.

At the business level, your startup can run scenarios that incorporate various external and internal factors to predict revenue.

A scenario analysis isn’t to be confused with a sensitivity analysis. While a scenario analysis changes variables simultaneously, a sensitivity analysis only changes a single variable to understand its individual impact on the outcome.

Why is Scenario Analysis Essential in Financial Modeling?

Scenario analysis is important in financial modeling because it can provide insight into what needs to go right – and what could go wrong – for your startup to reach a certain outcome. When you assess different variables, it allows leadership to identify opportunities, risks and make informed decisions based on various data points rather than just one variable.

Some of the big benefits of scenario analysis in financial modeling are:

• Allowing leaders to assess data and make strategic decisions.
• Maximizing transparency and communication with stakeholders and fellow employees.
• Being able to generate employee buy-in on hitting certain targets to achieve revenue goals.
• The opportunity to identify risks and opportunities.
• The ability to change your financial forecasts based on evolving market conditions or by learning new information.

Scenario analysis can also provide key information for forecasting cash flow, revenue and total costs.

Types of Scenarios to Include in Analysis

Startups are advised to run at least three types of scenarios when they model their finances: best-case scenario, worst-case scenario and the most likely, or base-case, scenario. These scenarios help in predicting outcomes such as cash flow, revenue, and the overall impact on the income statement.

The best-case scenario represents the most positive financial outcome with the most favorable conditions, while the worst-case scenario represents the opposite. The base-case scenario is the most likely outcome that you can expect based on the assumptions and data that you have.

Steps to Conduct Scenario Analysis in Financial Modeling

How do you conduct scenario analysis in financial modeling? Here’s a look at the steps that you’ll want to take:

• Start by identifying your assumptions and variables. This includes your key drivers, uncertainties and more. It’s important to have good data, as this will allow you to make better assumptions.
• Once you have the variables, it’s time to develop the different scenarios and make assumptions for each scenario.
• Create your structured scenarios using a program like Excel or special modeling software and calculate your potential outcomes within your financial model. Incorporating historical financial data can provide a solid foundation for these scenarios, enhancing their accuracy and reliability.
• Once you have your projected outcomes, you can analyze and compare results to draw conclusions about what factors could influence each outcome. This analysis should then be reflected in the financial statements to provide a comprehensive view of the potential impact.

Common Pitfalls in Scenario Analysis and How to Avoid Them

Scenario analysis in financial modeling isn’t without its challenges. Some of the key challenges that startups will want to avoid include:

• Overcomplicating things: To avoid this pain point, limit the number of scenarios to only the most critical ones, like best-case, worst-case and base-case. Don’t get too carried away with scenarios.
• Ignoring key variables: Don’t underestimate the impact that key variables can have on your outcome, especially those that may seemingly present themselves as low-risk. Failure to consider them could have a major impact on your startup.
• Gathering data: Make sure you’re gathering enough data to support any assumptions that you’re making. Inefficient data can lead to poor outcomes. This is especially crucial for projections that impact key reports like the cash flow statement, as inaccuracies here can significantly affect financial planning.

Additionally, a common pitfall is failing to communicate the scenarios to stakeholders and employees. It’s important to effectively communicate and act with transparency.

Advanced Tools for Scenario Analysis

Several tools can help with scenario analysis. Beyond Excel’s Scenario Manager, various advanced modeling tools can help take your efforts to new heights. These include Anaplan, Datarails, Planful and VenaSolutions. These tools help leaders better visualize data and offer features such as multi-dimensional planning, advanced scenario modeling, data checks, AI assistance and easy integration with other programs and platforms. Utilizing these tools with accurate historical data can improve the precision of your scenario analysis and provide a clearer view of potential future outcomes.

Real-World Applications of Scenario Analysis

You can apply scenario analysis to many real-world applications. From evaluating investment opportunities to assessing risk management and preparing for an economic downturn to assessing the impact that sudden market changes could have on your startup, scenario analysis can be applied to determine a range of possibilities. These analyses often influence key financial reports, such as the statement balance sheet, by providing insights into potential changes in assets, liabilities, and equity under different scenarios.

How Graphite Supports Your Scenario Analysis Needs

As experienced financial professionals, Graphite Financial is here to help support your startup’s scenario analysis needs. We specialize in helping startups with all of their financial needs, including scenario analysis and financial forecasting, and are standing by and ready to tailor our solutions to your situation. At Graphite, we’ll help your startup build reliable, robust financial models to facilitate its growth and prosperity in the future.

Preparing for Success with Scenario Analysis

Scenario analysis is important because it helps startups gauge risks and opportunities by exploring various outcomes and adjusting different variables. From identifying opportunities to improving decision-making, scenario analysis can help enhance strategic financial planning and set your startup up for revenue growth and success as it matures.

Partner with Graphite for Expert Financial Modeling

For more information on the importance of strategic planning and to learn more about how Graphite can help support your startup, contact us today. We tailor our services to your startup to ensure you’re getting the best possible service. You can also download our free financial model template. Contact us today to learn more and schedule a consultation.

FAQs

What is scenario analysis in financial modeling?

When mastering financial modeling, a scenario analysis will examine the impact that several variables have on an outcome. It can help a startup better anticipate change, prepare for certain events and create more effective strategies to meet any pre-determined goals. Many startups will use scenario analysis to project profitability over some time and how this projected profitability may fluctuate based on various conditions.

How does scenario analysis differ from sensitivity analysis?

A scenario analysis isn’t to be confused with a sensitivity analysis. While a scenario analysis changes variables simultaneously, a sensitivity analysis only changes a single variable to understand its individual impact on the outcome.

For example, a financial scenario analysis may weigh variables like sales price, rise in material costs and an economic downturn to determine anticipated revenue. A sensitivity analysis will only isolate one of these variables at a time.

What are the benefits of using scenario analysis?

A scenario analysis can help result in better decision-making. It can identify risks and opportunities, promote a more strategic mindset within your startup and also help anticipate how future financial performance and events may impact your operations.

What are the common pitfalls in scenario analysis?

Some common challenges in scenario analysis include overcomplicating the scenarios that you’re running, ignoring key variables, not gathering enough data to support assumptions, inefficient data and poor communication of results to stakeholders and employees.

Can scenario analysis predict economic downturns?

Not necessarily. However, scenario analysis can be a tool for identifying risks, which may include an economic downturn, and help your startup better prepare for it. In many scenario analyses, an economic downturn will often represent part of the “worst-case” outcome that is being determined.

What tools are best for conducting scenario analysis?

Beyond Excel’s Scenario Manager, various advanced modeling tools can help take your scenario analysis efforts to new heights. These include Anaplan, Datarails, Planful and VenaSolutions. These tools help leaders better visualize data and offer features such as multi-dimensional planning, advanced scenario modeling, data checks, AI assistance and easy integration with other programs and platforms.