The Importance of Reliable Scenario Analysis in Financial Forecasting
Finance and scenario analysis go hand in hand. As research from Stanford University summarizes, finance aims to utilize money efficiently. And the efficient use of money depends on two things: allocating capital wisely and successfully planning for a variety of possibilities.
While this may sound simple, it requires precision. Whether your organization is booming or revenue has plummeted, the decisions you make today will affect your outcomes tomorrow (and well into the future).
But how do you make decisions for the future when you don’t know what will happen? For instance, COVID-19 flipped the entire economy upside down, and we still don’t know where it will all lead.
So, how do financial analysts prepare their organizations for the unexpected? With scenario analysis. It’s the most powerful tool for planning around an uncertain future.
With scenario analysis, you can test assumptions and scenarios to examine your organization’s unique financial outlook, future-proof yourself against all potential risks, and capitalize on all potential opportunities.
Here, we’ll discuss what all you need to know about scenario analysis in financial forecasting, including the common pitfalls to avoid and the secrets to successfully use scenario analysis.
What is scenario analysis in financial modeling?
In simple terms, those in finance use scenario analysis to forecast what may happen and create a plan for what to do if certain situations arise. Scenario analysis is vital in financial modeling because it helps organizations understand risks, the impact of different market conditions, and the potential results of certain decisions.
Typically, you look at big picture metrics when doing scenario analysis in finance. You change inputs to see how different conditions affect cash flow, revenue growth, and net income.
For instance, if you work in the finance department of a logistics company, your firm may be considering expanding the warehouse. You're tasked with seeing if the investment makes sense.
During your scenario analysis, you may change inputs such as the purchase price of construction materials, cost of debt financing, and labor expenses to see how it affects your overall return on investment.
Scenario analysis and risk management are tied together. After all, an organization can’t grow if it doesn’t take on risk. In order to prepare for risks intelligently, you must vet every growth opportunity and every potential risk.
How can you plan for every possible outcome?
Scenario analysis in finance has to include all the interconnected factors within your business. This isn’t easy and has traditionally taken a lot of time to get right (and, at times, wrong). Adding new components and considerations in the mix can make financial modeling far more difficult.
Scenario analysis looks at everything in your business, from A to Z, to show you where you’ll end up. Notice the ‘ideal financial outcome.’ That’s the best-case scenario.
Now, scenario analysis in finance usually presents a range of future outcomes. These include:
- Worst-case scenario:
- If we return to the example above of expanding the warehouse, the worst-case scenario could be a negative return on investment. That could result from going over budget, bad macroeconomic conditions, poor strategic planning, and more.
- Most likely scenario (baseline scenario):
- This would be the expected return on investment. For example, if you don’t encounter any surprises, you may expect an annualized ROI of 20% from expanding the warehouse.
- Best-case scenario:
- The expanded warehouse enables you to take on a lot more business. Macroeconomic conditions are also favorable, and your strategic planning is flawless. The best-case scenario could be an annualized ROI of 50%+.
Scenario analysis in finance presents a wide range of possible future outcomes. It should also:
Scenario analysis in financial forecasting allows you to examine multiple inputs
Let’s return to the warehouse example. Your scenario analysis should allow you to test multiple inputs at once (such as what happens to your company’s bottom line if construction goes over budget, but you get a cheaper loan, and you get two new projects lined up).
Tell a story about the future
Scenario analysis in finance isn’t meant to give you exact details. You can’t calculate the future. But you can see all the possible ways large capital projects and initiatives can impact your business.
Proper scenario analysis prepares you for all possible futures—even those impacted by external factors. Ultimately, that level of preparation is key to keeping your business financially solvent and growing.
How can analysts and other finance professionals perform better scenario analysis in financial forecasting?
An article in MIT Sloan Management Review sums it up. Scenario analysis enables firms to see:
- What actions they should take now
- What actions they should stop now
- What actions they may have to take in the future
Scenario analysis doesn’t hide uncertainty—it prepares you for it. It doesn’t give you a single course of action, but rather prepares you to make the best decision no matter what may happen in the future.
As you know, any investment carries risk. You must be proactive if you wish to avoid losses and realize solid returns. Intelligent scenario analysis in financial forecasting should steer you away from bad investments or risky decisions.
In order do this correctly, you need adaptable financial models, something advanced scenario analysis solutions can provide:
- Future-Proof Your Organization: You can answer tomorrow’s questions today.
- Real-Time, Data-Informed Decisions: You can take out the guessing and make decisions based on present realities.
- Risk Management: You understand what external events and internal risks could lead to negative outcomes (and know what measures could prevent such outcomes).
- Proactive Strategizing: You don’t handle problems as they come. Instead, you prepare for them before they arrive.
How do you perform scenario analysis?
Think of a billiards table and the game of snooker, in particular. You have a full-field view of each shot you can make. You can envision how one shot might impact the rest of the table. This way, you don’t take shots that put you at a disadvantage for the rest of the game.
In fact, the inherent nature of the game requires that you’re able to do this competently. Players are forced to anticipate how to place the cue ball after each shot to line up their next one. If they don’t, they expose themselves to unnecessary risk (in this case, a much harder follow-up shot).
Similarly, scenario analysis should provide you with a full view of your organization and how each aspect of a business is impacted by any given project, initiative, or strategic direction. This way, you don’t make decisions that harm any part of your business.
To perform scenario analysis, finance teams should set up their models to do the following:
Allow for many variables. As a McKinsey article notes, scenario analysis should be multivariate because the future is multivariate. Your model should enable many assumptions to exist at once so you can see how the business is impacted by one or more changes. Examples of assumptions at your organization could be:
Cost of goods sold
Interest on debt
Rent and overhead
Depreciation and amortization
Organize all your scenarios. You should have an upside case, downside case, and most likely case. Ideally, you have a range of scenarios that consider all the futures your organization could encounter. You also need to display the differences in each scenario in a dynamic format so stakeholders and non-finance leaders can easily identify impacts.
Be dynamic. Analysts need to structure their financial models so that data can be updated quickly as economic conditions or business operations change. Think of how the CHOOSE function in Excel works; it allows you to pick between multiple scenarios. Build your model so that updating the live scenario is as easy as toggling a switch on and off.
Focus on high-level decisions. While it’s crucial to set up your financial models correctly, you have to remember the high-level decisions your model is helping stakeholders make. Ensure the model clearly shows what assumptions and actions lead to the company achieving its goals for internal rate of return (IRR), equity value per share, and other key metrics.
Test unlimited sets of assumptions. Within a single financial model, your scenario analysis should allow you to change different assumptions and test all sorts of combinations. While this requires an advanced modeling structure, it will provide you with plans to adapt to any industry shift of economic condition.
Be futuristic. To survive an uncertain future, you have to think like a futurist. As research from Deloitte notes, your scenario thinking and design should incorporate trends in your industry. For example, no university should build a scenario model without accounting for remote learning. No agricultural company can do scenario analysis without considering climate change. And commercial real estate firms have to factor in long-term shifts in property taxes, housing demand, and maintenance.
Where scenario analysis in financial modeling goes wrong
How do you calculate all these scenarios? You open up a new Excel spreadsheet, right?
Sure, you could do that. But if we’re being honest with ourselves, Excel (and any spreadsheet-based solution like Excel) isn’t exactly the Rolls Royce of financial modeling solutions. It’s not even a Toyota Yaris!
Sure, historically, scenario analysis has been done in spreadsheets. But that’s because there were no other viable options. Spreadsheets aren’t built specifically for financial modeling, forecasting, or scenario analysis.
Moreover, building a quality model requires securely integrating a lot of complex moving parts. If you do try to do that in a spreadsheet, you’ll run into some major issues, such as:
- Having hundreds of spreadsheets linked together: This gets confusing and leads to countless mistakes. Spreadsheet errors have cost organizations like Fidelity billions. Why take the risk?
- Wasting too much time: Even advanced Excel users waste up to 10 hours per week doing manual spreadsheet work. That time could be spent on more strategic activities.
- Being two-dimensional: Traditional scenario modeling leaves you unable to test unlimited sets of assumptions, as spreadsheets only give you the ability to test ‘if… else’ statements. This makes it hard to plan for all possible scenarios.
- Static models: To update anything in real-time, you have to do it manually. You may also have to spend time altering the underlying math to adjust for any current situation.
- Lack of clarity:Given the static, confusing nature of scenario modeling spreadsheets, communication with stakeholders can be difficult. Having clarity and consensus becomes much harder.
Financial forecasting doesn’t have to be so difficult
At Synario, we believe in the power of scenario analysis to make organizations financially sustainable over the long term. That’s what’s motivated us to come up with a solution to the problems spreadsheets cause.
With Synario, you get access to a scenario analysis tool that can help you test an unlimited number of assumptions at once, in real time, all within a single financial model.
Scenario accomplishes this by giving you the power to build a multi-dimensional model to suit your business. Thanks to our patented layering technology (think how you can toggle different layers in Photoshop on and off), our models allow you to consider multiple combinations of variables and assumptions in a fraction of the time it would take you in Excel.
Want to learn more about how to master scenario analysis? Contact us, and we’ll help you build a financial model that truly empowers your team.