The Importance of Scenario Analysis
The importance of scenario analysis can’t be understated. When used correctly, scenario analysis enables you to future-proof your organization. It helps you not only anticipate and prepare for risks, but also capitalize on opportunities.
But how do you predict the future when there are so many variables to consider?
Like in a chess match, you can anticipate some scenarios several moves in advance. However, with your intuition alone, you can never know precisely the moves your opponent will make—only possible moves based on how the pieces are positioned on the board.
This is why chess computers completely outclass even the best chess grandmasters, like Magnus Carlsen. A chess computer can not only see every possible move in advance (and accurately predict the probability of each move happening), it can also process mountains of data in seconds before arriving at the best decision.
If you actually had a supercomputer that could help you perform advanced scenario analysis during your chess games, you’d be able to see all your opponent’s potential moves—even before they do! And you’d have the clarity and confidence to make the best decisions no matter what happens.
Imagine the kind of edge that foresight would give you in business.
Let’s go over exactly how you can use scenario analysis to create long-term, multi-year plans and successfully adapt to any economic condition, market trend, or industry event.
The Importance of Scenario Analysis
To give you a more clear picture of the importance of scenario analysis, let’s start with a simple example. Imagine a private college has to undertake five capital projects to meet the needs of a growing student body. These projects include:
- Dorm Remodel
- Parking Deck
- Townhome Development
- New Residence Hall
- Enterprise Resource Planning (ERP) System Implementation
With multiple major projects ongoing at once, the college must make careful decisions about how to fund and prioritize these projects. Otherwise, they risk delays, going over budget, and causing disruptions on campus.
Poor decision-making with any of these projects could affect the long-term financial sustainability of the institution.
Funding The Capital Projects
The college examines how different types of financing impact their operating margin, debt service coverage ratio, and liquidity ratio. They analyze three funding scenarios:
- Fully fund the projects with cash reserves:
- The result: Though the college had the financial reserves, utilizing that money would leave them with a low liquidity ratio during years 3 to 5 of the 10-year period.
- The decision: Because fully funding the projects with cash would make it difficult to handle unexpected expenses, the college decides not to use this funding strategy. It’s too risky.
- Fully fund the projects with debt:
- The result: This seems like a good option, as interest rates remain near historic lows. Scenario analysis showed operating margins and liquidity would remain healthy over the next decade. However, the college’s debt coverage service ratio would get too high in years 6 to 10.
- The decision: Because fully funding the projects with debt could put too much stress on the institution’s finances and hurt their credit, the college decides not to use this funding strategy.
- Fund the projects with a mix of cash and debt:
- The result: Scenario analysis shows that a mix of 40% cash and 60% debt not only keeps debt service coverage ratios at acceptable levels throughout the next decade, but also maintains a healthy liquidity ratio and solid operating margins.
- The decision: The college decides to choose this funding strategy, as it puts them in the best position to handle unexpected challenges, mitigate risks, and seize opportunities over the next ten years.
With each scenario, analysts query the model, asking ‘what-if’ questions to see how financials change as enrollment, faculty salaries, interest rates, and more fluctuate. This allows stakeholders to see all potential future outcomes and choose the best course of action.
Prioritizing Capital Projects
The college also uses scenario analysis to prioritize these five projects. By testing various sets of assumptions and scenarios, the college sees that removing the two housing initiatives puts them in the best position financially. However, forgoing construction on those two student residences would stunt enrollment growth.
Through scenario analysis, the college determines an alternative solution: Lease and renovate an off-campus apartment community. This enables the college to accommodate a growing student population while maintaining financial health.
What Happens When You Don't Use Scenario Analysis?
Without testing all those sets of assumptions and scenarios, the college would not only fail to see how their choice of funding precisely impacts the institution’s financial sustainability, but they would also fail to identify strategies that enable them to capture all the revenue from a growing student population.
Simply put, without scenario analysis, the college is much more likely to make a decision that will negatively impact their future financial position. And that could put the future of their organization in jeopardy. Perhaps most importantly, scenario analysis enables businesses and organizations to assess and prepare for future risks in a dynamic, adaptable manner.
As a guide on decision analysis tools from the University of Baltimore states, scenario analysis considers the worst and best sets of circumstances, comparing them to the expected output (base-case) by testing the sensitivity of those projections to changes in key variables.
Through such testing, scenario analysis helps you cope with risk. You can:
- Avoid activities and strategies that present too much risk.
- Reduce the possibility of losses occurring.
- Use strategies to transfer risk elsewhere.
- Prepare for risks by setting aside funds.
- Reduce risks by diversifying plans.
It’s important to use scenarios so that you can view the whole range of future possibilities. As Thomas Frénéhard, an expert in financial risk, explains, businesses typically only look at the tip of the iceberg when doing risk-based auditing. Tools like Synario help businesses uncover the cascading ramifications of today’s mission-critical decisions (i.e., the hidden majority of our hypothetical risk iceberg.).
That’s why Frénéhard advises the use of scenario analysis: It allows teams to focus on mitigating underlying risks, those risks that lurk beneath the surface. You can’t predict the future—but you can plan for it.
Now, you may ask: What sort of risks lurk beneath the surface? How can you possibly prepare for what you can’t see?
Well, without scenario analysis, you can’t.
Scenario Analysis Future-Proofs Your Organization
When presenting to stakeholders, it can be difficult for analysts and CFOs to show how the organization should adapt to externalities. Internal and external factors change almost daily, and they aren’t always predictable.
If you don’t have a strong and reliable method for performing scenario analysis, you can’t create a dynamic, adaptable, multi-year plan to manage potential risks and capitalize on lucrative financial outcomes.
For example, advanced scenario analysis software would allow companies to quickly see how outcomes change if they achieve a certain level of sales growth, add personnel, create a new product, go through with a capital project, and much more.
The ability to plan for the unexpected is key to long-term success. There’s no greater proof of this than the COVID-19 pandemic, which sucker-punched countless businesses and institutions around the world that were not prepared for all eventualities.
The good news is that smart scenario analysis makes creating a COVID-19 strategy much easier.
Again, let’s return to the example of the college. Just as the college began implementing its capital projects, COVID-19 hit, leading to campus closure and a shift to online learning. But they didn’t have to throw away their financial models. They were prepared for the unexpected.
The college tweaked and turned off the capital project scenarios and incorporated new initiatives to address the impact of the pandemic. This enabled them to quickly adapt their financial strategy and present it to stakeholders.
Ultimately, the institution was able to get a head start on reorienting their plans and put themselves in a much better position to come out on the other side and thrive.
Making Scenario Analysis Work For You
Now that you know the importance of scenario analysis, there’s only one thing left to do: avoid spreadsheet-based solutions. Sometimes, they create even more problems than they solve, such as:
- Make your models mistake-prone: Too much manual entry gives human error a lot of wiggle room, which compromises the integrity of any model. It’s no surprise that nearly 90% of spreadsheets have errors.
- Expose your models to version errors: When you’re updating and saving multiple spreadsheets, it’s easy to mess up sharing permissions (and potentially compromise the security of the spreadsheet). It’s also easy for team members to accidentally waste time updating an older version when a newer version already exists.
- Leave you with a narrow view: When you create a financial model in a spreadsheet, you do so with a certain set of assumptions and questions that need to be answered. You can’t test unlimited sets of assumptions at once, as you have to go back and change the underlying math and adjust formulas.
- Leaving you with a static model: Successful scenario analysis requires dynamic financial models. By the time your CFO presents your carefully crafted spreadsheet projections to stakeholders, they’re already outdated due to newly available information.
- Waste your time needlessly: Even advanced spreadsheet users spend nine hours per week doing manual spreadsheet work, per person. And you already know that a lot of those hours are spent agonizing over little details that shouldn’t be so difficult to get right.
Scenario Analysis Made Easy
At Synario, we understand the importance of scenario analysis in making organizations more sustainable and successful. That’s why we built Synario, an easy-to-use, customizable, multi-dimensional modeling solution that suits your organization’s specific needs.
With our scenario analysis and financial modeling software, you can test multiple assumptions just by turning variables on and off and toggling values with adjustable sliders. There’s no need to build a new spreadsheet for every set of questions you want to answer.
Efficient and mistake-proof, our model comes as an out-of-the-box solution that can be customized as needed. All the formulas and algorithms you need are built into the solution. This helps your analysts save countless hours each quarter and makes it far less likely for human error to compromise the integrity of your models.
Do you want to have a single source of truth for planning your future? Just click below, and we’ll help you build a financial model that empowers and future-proofs your organization.