2022 is not just another year of challenges for treasury professionals. It is a year with a daunting array of challenges – cybersecurity threats, currency volatility, commodity price swings, China’s economic slowdown, inflation, rising interest rates, geopolitical uncertainty, the global energy crisis, pandemic impacts and supply chain disruptions.
Uncertainty can be a major obstacle to effective decision-making. However, treasury executives can leverage sensitivity and scenario analysis to make better decisions during uncertain times.
Putting together a well-rounded analysis before making decisions pertaining to acquisitions, product investments and raising capital is imperative and may change how and when treasurers approach such investment and financing decisions.
Investment and financing decisions are based on a set of assumptions and inputs that always come with a certain level of risk. Before making an investment, treasury can use these two analytical methods to assess the magnitude of such risks and weigh it against potential benefits. This will help determine the best possible investments.
So what is the differences between sensitivity and scenario analysis, and what are the advantages of using them together?
Sensitivity analysis versus scenario analysis
Sensitivity analysis, also known as “what-if” analysis, helps predict how an outcome might change if a variable in that situation changes. Simply put, it examines to what extent the outcome will change based on tweaking just one input or changing a single variable at a time.
For example, sensitivity analysis can be used to study the effect of a change in interest rates on bond prices if the interest rates were to be hiked by 1%. Another example would be to examine how a change in the lending or borrowing rate could affect the company’s profitability or cash flow.
Scenario analysis, on the other hand, explores a range of potential outcomes from base-case to worst-case scenarios (base-case, best-case, and worst-case). In essence, it examines how the outcome changes based on changing all the input variables or the existing variables at the same time.
For instance, in the worst-case scenario, a treasurer considers an array of negative factors or assumptions that will impact the outcome. These factors include rising interest rates, inflation, supply chain disruptions, currency volatility, economic recession and reduced sales. Here each input value is set to its worst, and the treasurer considers the most severe outcomes in any given situation.
Another example would be the best-case scenario or the most optimistic projected investment outcome for the organization. The treasurer includes the highest possible growth rate, the least discount rate and the lowest possible tax rate to calculate the net present value (NPV).
Advantages of sensitivity analysis and scenario analysis
Sensitivity analysis helps examine different combinations of the input or independent (assumption) and output or dependent (the outcome) variables, their association and how they impact business decisions. This ensures that each independent variable and its effect on the dependent variable is analysed, the movements studied, and the results compared.
Thus, sensitivity analysis facilitates an in-depth assessment and a more comprehensive understanding of which variables or assumptions have a high impact on success or failure (greatest and weakest impact), leading to a more accurate forecast.
Sensitivity analysis is used to predict the return on investment for a specific project. It is also useful for risk management and to take advantage of opportunities in times of crisis.
Scenario analysis focuses less on definitive or accurate outcomes and more so on predicting the likely positive and negative outcomes that are valid, although uncertain. This allows treasurers to quantify and analyse a wide variety of situations and potential business impacts and to better prepare. In addition, it facilitates quick and effective decisions and provides clarity on how to prudently allocate resources to avoid or limit losses from adverse consequences or uncontrollable factors that may arise in the future.
Scenario analysis adds value by giving investors an understanding of the expected returns when making important investment decisions. It can also be used to determine what needs to be done to increase revenue and profit by a certain amount.
Reap the benefits from using sensitivity and scenario analysis together
2022 may be the year of uncertainty. Most of the world’s largest economies are stalling. Higher-than-expected inflation in the US and major European economies is triggering a tightening of global financial conditions. China’s economic slowdown has been worse than anticipated, and the spillover effects from the Russia-Ukraine war are being felt worldwide.
Assessing challenges and managing unknowns and uncertainty in an unpredictable world is fraught with risks, but treasury professionals can reap a lot of benefits from using the two analytical methods together, particularly to get a comprehensive view of potential outcomes that will lead to more accurate forecasts and diminished risks.
Standalone analysis – either sensitivity analysis or scenario analysis – would not provide a complete picture. Combining these analysis methods will help treasury know the full range of outcomes, including all the extremes, so that they can then come up with plans to mitigate the impact of unexpected events in challenging times.
To conclude, sensitivity and scenario analysis if used in conjunction with one another can become a powerful tool in a treasury’s arsenal. They can help intelligently position the business through informed analysis and decision-making. Reap the benefits by using the two together to forecast and plan with a heightened degree of confidence.
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