Definition of a Sensitivity Analysis
Decision-makers can examine how changes to critical input variables affect financial model output with the help of sensitivity analysis, a powerful financial modeling tool.
Sensitivity analysis helps businesses improve the quality of their financial decision-making by identifying risks and opportunities by studying the interactions between independent and dependent variables.
When performing a budget, a sensitivity analysis looks at how the numbers change when key assumptions are altered.
It can be done with a spreadsheet or by hand computations and is sometimes called a “what-if” analysis.
If only the variable costs in the budget are included during the manual computations, the process becomes much more manageable.
Why Sensitivity Analysis Is Necessary
There are several crucial uses for sensitivity analysis in modern business.
For instance, you can use sensitivity analysis to learn how the cash budget reacts to shifts in the starting point.
If the monetary impact of changing one assumption is negligible, then there is no need for alarm.
However, significant variations in cash flow can occur when just one assumption is altered.
Therefore, a sensitivity analysis might help you figure out which assumptions are most important.
To make sure that managers are prepared for any possible deviation from our baseline projections, this method explores the effect that modifications would have on the budget.
The term “what-if analysis” can be used interchangeably with “sensitivity analysis.” This is a fantastic moniker because it accurately conveys the subject matter covered.
The method only illustrates to the analyst the repercussions the alterations will have on the budget.
A sensitivity analysis is a method for evaluating the impact of a change by “trying out” a number of potential variations from the base case.
To do this, just adjust one type of income or expenditure (for instance, what if the purchase price goes up by 5%).
The impact of many changes can also be examined (for instance, what if the purchase price rises by 5% and we have to pay off a loan in one month, rather than two) to reach this goal.
Since sensitivity analysis may be required of you in some situations, we will look at the numerical methods involved in a moment.
Before we get to that, though, let’s take a look at a useful tool for performing sensitivity analysis in the real world: the computer spreadsheet.
Sensitivity Analysis with a Spreadsheet
A monetary budget can be easily recreated in spreadsheet form. To save time and effort, we employ formulas to calculate values for us.
Inputting data or adding new rows/columns (for more receipts/payments, for example) is a breeze once a spreadsheet has been opened.
When a cash budget spreadsheet is set up properly, the sum of all cash inflows and outflows, as well as the cash and bank balances at the bottom, will update in real time if any adjustments are made.
Below is an illustration of a cash budget plan. This example serves as two illustrations:
Normal perspective, with figures clearly seen (top illustration).
Here we see the formulas from a different perspective (bottom picture).
Although it can be challenging to incorporate spreadsheets into AAT simulations, computer modeling is a part of the required knowledge and expertise for this subject.
Using a Manual Approach to Sensitivity Analysis
There are typically three classes of adjustments made in a sensitivity analysis. The following sections elaborate on these classes.
1. Shifts in the Volumes Below the Surface
Changes in underlying volumes include shifts in the number of units sold, produced, or bought.
Costs that weren’t originally anticipated (such renting or purchasing more machinery) could fall under this category as well.
2. Price shifts
Simple adjustments to prices will be the focus at first. We’ll look at inflation’s effects and possible solutions in the next section.
3. Variable Timing
The impact of scenarios where cash inflows and outflows are identical to the initial cash budget but occur at different dates must also be evaluated.
Allowing longer (or shorter) credit terms on sales, or delaying payments on purchases or other outgoings, are all examples.
There are two methods for modifying the cash budget information:
Although easy in spreadsheets, reworking the entire cash budget by hand can take a lot of time if there are multiple alternatives to consider.
Determine how the recommended adjustments would affect your monthly cash flow: This method calls for some analytical thinking, but it’s faster than starting over with the budget.
In AAT simulations, the second method is frequently necessary. The method by which this is accomplished will now be dissected in greater depth.
The trick is to treat each month as unique, with its own set of computations.
Any shift in earnings, and
Any adjustments to payments that result in
Modifications to the flow of money
After making the necessary adjustments, the revised cash balance for the month can be determined and carried over to the following month. The work can be done in a table format.
Cases of Sensitivity Analysis
To illustrate how sensitivity analysis works, we will use a simple example.
The following cash flow forecast assumes all sales will be made with a two-month credit period. We anticipate $8,000 in March sales.
Let’s pretend we need to calculate the results of switching the payment conditions of January sales to one month’s credit. For the sake of convenience, we will presume that all of our clients are in accordance with the new conditions.