What Is Scenario Analysis and How Can It Future-Proof Your Business?
Every company on earth wants a “future-proof” business model. But unless you have a working time machine that can take you to the future, there’s no way to enjoy complete certainty over what tomorrow will bring.
That’s why there’s scenario analysis—the next best thing to a time machine.
Let’s review what scenario analysis is, why it’s important for staying solvent, and how you can use it to improve your budgeting, forecasting, and decision-making. We’ll also cover some of the best tools for the job.
The Importance of Scenario Analysis
The problem with trying to predict the future is that there are often too many factors to consider. In order to future proof your business, you’d have to be able to anticipate every possible risk and roadblock that could stop or slow you down.
This could include anything and everything from aggressive competitors to a failed product launch. You also need to anticipate how to capitalize on potential growth opportunities should they arise.
Let’s say you run a university that wants to remodel a dormitory. You could fund the project in three major ways:
- Fund the dorm remodeling completely with cash reserves: This decision avoids debt, but scenario planning predicts this will yield low liquidity over the next decade.
- Fund the dorm remodeling completely with debt: With low interest rates, scenario planning indicates this decision would keep liquidity high. However, it may also increase the debt coverage service ratio in the next 6–10 years.
- Fund the dorm remodeling with both cash and debt: Scenario planning shows that this will allow for liquidity while maintaining healthy operating margins.
If you decide to go with option 3, for example, you will have to account for new variables, such as cash-to-debt ratios, the extent of remodeling required, and even the state of the overall economy (just to name a few).
These three choices only scratch the surface of what’s possible with scenario analysis.
What Happens If You Don’t Prepare For Every Outcome?
When budgeting for a significant multi-year project or investment, many businesses only consider the tip of the iceberg, overlooking a mountain of hidden risks and rewards.
But if you don’t successfully identify all possible scenarios or properly run your scenario analysis, there is no way you are anticipating or preparing for all possible outcomes. Two big problems emerge when scenario analysis is neglected:
- Failure to anticipate and avoid all potential problems (or the full impact of those problems)
- Failure to capitalize on growth opportunities (because you didn’t see them coming)
Consider the COVID-19 pandemic. Scenario planning was crucial for survival. Many companies found ways to pivot and restructure their products or offerings, but many others did not.
While many analysts turn to spreadsheet-based solutions like Excel for scenario planning, this is not always the best idea. Spreadsheet-based solutions suffer from multiple design flaws, including:
- Human error: With repetitive manual entry and multiple spreadsheets floating around, there are numerous ways in which human error can compromise the integrity of a spreadsheet-based financial model.
- Limited scope: Spreadsheets are two-dimensional and very limited in terms of the answers they can offer. Analysts waste countless hours double-checking their work and building new spreadsheets from scratch whenever stakeholders have new questions.
- Static models: While you can paint a picture with spreadsheets, it’s static and undynamic. You won’t be able to adjust variables in real-time to showcase at a meeting with the CEO or stakeholders, and you have to put together a presentation from scratch.
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Forecasting is much more than just running basic revenue projections—it’s about weighing all the potential risks, market conditions, and opportunities your business might experience for several years going forward.
While no single analysis can paint a comprehensive picture of what the future may hold, rigorous scenario analysis provides crucial insights into which business decisions could lead to growth, insolvency, or little to no change.
Company-wide decisions have company-wide ramifications. Adding a sales team in one department, for example, doesn’t just change the fortunes of that department. Additional revenues (or losses) can have far-reaching effects on a company as a whole.
Common Scenarios You’ll Consider
There are multiple variables and assumptions to consider when building a financial model and performing a scenario analysis. Three of the most common include:
- Worst-Case Scenario: This is one of two less likely outcomes (the other being the best-case scenario). In this scenario, the new sales team has little to no impact on sales, and the money spent hiring them is a sunk cost. Even more money will have to be spent on replacing them or drumming up sales in some other way.
- Baseline Scenario: This is the most likely outcome. Let’s say that after 3 to 6 months of training, the sales team brings in modest revenue growth, and perhaps a bigger “whale” account once in a while. The sales team is an investment that’s paying dividends, but they aren’t rock stars.
- Best-Case Scenario: In this scenario, the sales team you hired all turn out to be rock stars. Their desks are covered in business cards, and their conversion rates are much better than expected. In fact, they’re closing a new “whale” account every month. This could open the door for rapid expansion and transform your company’s fortunes.
Keep in mind that scenario analysis is about more than just considering outcomes—it’s about identifying the variables that affect the outcomes. What combination of triggers leads to specific events? Proper scenario analysis allows you to:
- Examine multiple inputs: An analyst’s job isn’t just to determine every possible risk. Scenario analysis helps decision-makers identify all dependent and independent variables and how they interact to lead to different outcomes, as well as the probability of each outcome occurring in the first place.
- Tell an easy-to-follow story: No matter how great your analysis, you still need to present it to stakeholders and decision-makers who may not have the training to interpret the data without data visualizations.
Scenario analysis provides you a framework for making strategic, real-time, informed decisions grounded in proper risk management. Understanding every outcome gives you the power to avoid bad investments and risky decisions so you can achieve the most optimal outcomes.
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A Real-World Scenario Analysis Example
Imagine a successful regional bank chain. John, the founder, has already opened four branches and is looking to expand even further. Of course, in the time of COVID-19, nothing is certain for brick-and-mortar locations.
That’s why John is evaluating two very different options for his fifth branch:
- A: Somewhere downtown in the neighboring city
- B: On the main street in a small neighboring town
Unsure which location to choose, John begins by gathering data. He reviews the numbers for all four of his existing branches over the last five years. Each of the four locations tells a different story. After factoring in all expenses and overhead, John determines a reasonable growth trajectory for the fifth location.
If John were less diligent, he could have just averaged the numbers from all four branch locations to arrive at an estimate for the costs of setting up his fifth location, as well as its expected year-over-year growth. But that would be taking a very one-dimensional view.
Preparing For The Unexpected
Proper scenario analysis implies a multidimensional outlook. For instance, Branch 1 and Branch 2 might both enjoy $500,000 in annual sales, but the services sold and the price per service could vary dramatically.
John has to consider which variables matter for his new location and which ones don’t. For instance, the city location may have higher upfront costs but more foot traffic, while the main street in the smaller town might experience diminishing foot traffic over the next 10 years.
Let’s say, hypothetically, that John decides to go with the main street location anyway. He determines that he’ll take the lower returns any day as long as they come with a much lower upfront investment.
John is 100% confident he made the right decision… until a Chase Bank opens up right across the street from his new location. Now, what are his options?
He could take a loss on his initial investment.
He could use the equipment he already purchased and see if the downtown location is still available.
Or, he could stick it out and try to compete with Chase for customers.
With so many “what ifs” and unexpected variables, it will be difficult for spreadsheets to adequately meet John’s needs. He realizes that he needs a much more powerful scenario analysis solution—one capable of running multiple scenarios quickly and efficiently—to help him get the whole story before making his decision.
How To Perform A Scenario Analysis in Excel
Although spreadsheets are limited in scope and capabilities, they may still be the best option for many independently owned businesses like John’s. He decides he wants to review Excel’s strengths and weaknesses.
One of Excel’s biggest strengths is that it offers users a blank canvas. But building spreadsheets from scratch is extremely time-consuming, needlessly complex, and very prone to human error.
Let’s say you’re performing simple sales projections. You can enter the baseline variables (such as SKU, price, and quantity) to get simple revenue projections. Then you can use the “Scenario Manager” under “What-If Analysis” to run a basic scenario analysis.
This allows John to get straightforward projections of different sales cycles. In this particular example, Excel serves its purpose and is a decent-enough tool for the job.
Complex Scenario Analysis In Excel
But what if we encounter more complex situations? Excel has a tool for that as well, known as the “Scenario Merger” wizard. It allows you to combine multiple worksheets together into a single workbook to perform more complex analyses.
On the one hand, this may seem like an adequate solution. Most financial analysts are comfortable with Excel, and the program allows for a level of customization. On the other hand, when you actually try to execute these complex scenario analyses, things can get out of hand quickly.
Financial models are often shared across multiple departments and points of contact with different permissions and editing privileges. Just sharing an Excel spreadsheet with the right people (and making sure they save their edits in the right format and Reply All each time) can be a nightmare.
Each spreadsheet version must be formatted the same way to avoid confusion among collaborators. For instance, the “Items Sold” cell needs to be in A2 on all files, or you are opening up a can of worms.
And with each new point of contact and degree of separation, your financial model is exposed to a new source of potential human error that could compromise the integrity of the model. It’s no surprise that up to 88% of all spreadsheets contain errors—some of which have cost companies billions.
Simply put, there are better solutions out there for advanced scenario analysis. Excel just doesn’t cut it sometimes.
Is Your Business Ready For Whatever The Future Holds?
Not only is future-proofing your business achievable—we’ve made it the primary focus of our entire company. Synario was founded by entrepreneurs who used Excel since its inception and knew there had to be a better way to arrive at smart business decisions.
Stop poring over every single cell of your spreadsheets. Synario’s patented Multiverse Modeling™ technology allows you to run as many scenarios as you want within a single model and see results update in real-time.
This can drastically reduce the time it takes to get your financial model from your computer to the boardroom. Even better, Synario’s presentation mode allows you to turn your results into an easy-to-understand presentation for stakeholders with a click of a button.
What does the future hold for your business? Let’s find out.