Financial Sensitivity Analysis

Financial Sensitivity Analysis is often a part of financial and feasibility studies

and includes testing the project cash flow sensitivity to alternative plans,
attendance projections (forecasts) and operating strategies. Other variables
might be project size and operating parameters, pricing, or market response

Feasibility studies and sensitivity analyses are important to assess whether

and how to pursue potential growth opportunities for the company.

Avenue M business advisors work with a company before starting a project

to analyze the feasibility of the potential project given different business
factors and variables. Based upon the analysis performed, a company may or
may not decide to move forward with the project based upon the cost benefit
analysis.

How to Do Risk & Sensitivity Analysis

in a Feasibility Study
Are you conducting feasibility study on a business project and need help doing the
analysis? If YES, here is a complete guide on how to do risk and sensitivity analysis.

The rate at which businesses fail can be traced to lack of business training. Most people jump
into a new business once they notice that the business is trending and highly profitable. They fail
to carry out their due diligence to know if the business is worth investing in. Part of what you
need to do aside undergoing business training before starting your business is to conduct risks
and sensitivity analysis for your business.

What is Risk and Sensitivity Analysis?

Conducting risks and sensitivity analysis involves accessing all the risks and sensitive areas that
is associated with the type of business you want to start. As a matter of fact, there is no business
that is not prone to risks and it is your responsibility as an entrepreneur to access the risks
involved in running the type of business you are about to start and also to know whether you
have what it takes to shoulder the risks.

Likewise, sensitivity analysis will help you put measure in place that will help you predict the
outcome of all the business decisions you make. Simply put, sensitivity analysis will help you
increase your understanding of the existing relationship between input and output variables in
your business. It is a known fact that succeeding or failing in business is all about the decisions
you make.

Although conducting risks and sensitivity analysis will not help you to totally eliminate all the
uncertainties of making business decision, but you are sure that it will help you minimize the
uncertainty to the barest minimum. Now here the steps you would need to follow to be able to
effectively conduct risks and sensitive analysis for your business;

How to Do Risk & Sensitivity Analysis in a

Feasibility Study
1. Study and Research

To start with, if you have never conducted a risk and sensitivity analysis for a business before,
then you have a lot of work to do. What is expected of you is to spend enough time studying and
researching on the subject – risk and sensitivity analysis.

There are materials online and in libraries that will help you achieve your aim of conducting a
risk and sensitivity analysis for your business. The truth is that conducting risks and sensitivity
analysis is usually done by experts because of the technicality involved, but you can do it
yourself if you spend time to study existing models.

2. Collect and Analyze Data and Graphs

Part of what you need to do when studying and researching on risks and sensitivity analysis is to
collect and analyze data and graphs that are related to your business. Once you are able to
properly analyze data and interpret graphs, it will give you an edge when conducting your risks
and sensitivity analysis.

You will be able to pin point areas where you would need to concentrate on. As a matter of fact,
you can not effectively conduct risks and sensitivity analysis without the skills to properly
analyze graphs and interpret data.

3. Develop a Theoretical Framework for Using Risks and Sensitivity Analysis for Decision
Making

Once you are able to analyze the required data and graphs, what is expected of you to do is to
develop a theoretical framework for using risks and sensitivity analysis for decision making. The
essence of conducting risks and sensitivity analysis for your business is to put structures in place
that will help you mitigate risks and uncertainty in your business and in turn maximize profits.
You can work with experts to help you create a model that is suitable for your business.

4. Run the Model a Number of Times before Adopting It

It is one thing to develop a theoretical framework that will guide you in decision making in your
business, it is entirely another thing for the model to work in real life situation. It is important to
run the model you developed for risks and sensitivity analysis for your business a number of
times before adopting it in your business.

What is the use of having a fantastic theoretical framework on paper without it working in real
life situation? The best time to adjust your theoretical framework is during the process of test
running it; once you discover any drawback, then you should go back to the drawing board and
restructure or adjust your framework.

5. Review the Document Generated From Your Risks and Sensitivity Analysis

Once you are done with all the steps listed above, you would have succeeded in completing your
risks and sensitivity analysis for your business and also you will be able to produce a
comprehensive document in that regard. The process will not be complete if you do not review
the document generated from your risks and sensitivity analysis. You can engage the services of
a professional to help you review the document.

Over and above, if you are successful in conducting your own risks and sensitivity analysis for
your business, you would have succeeded in finding the possible outcomes of most of the
business decisions that you will make in your business and you will be well guided. As a matter
of fact, some folks consider risks and sensitivity analysis as a systematic common sense
technique adopted by many business owners to minimize making wrong decisions that will cost
the company.
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(FMVA)®. Enroll today to advance your career!

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What is Sensitivity Analysis?

A guide to sensitivity analysis

Home › Resources › Knowledge › Financial

Modeling › What is Sensitivity Analysis?
Overview of sensitivity analysis

What is sensitivity analysis?

Sensitivity Analysis is a tool used in financial modeling to analyze how the different values of a
set of independent variables affect a specific dependent variable under certain specific
conditions. In general, Sensitivity Analysis is used in a wide range of fields, ranging from
biology and geography to economics and engineering.

It is especially useful in the study and analysis of a “Black Box Processes” where the output is an
opaque function of several inputs. An opaque function or process is one which for some reason
can’t be studied and analyzed. For example, climate models in geography are usually very
complex. As a result, the exact relationship between the inputs and outputs are not well
understood.
Image from CFI’s Scenario & Sensitivity Analysis in Excel Course
What-If analysis
A Financial Sensitivity Analysis, also known as a What-If analysis or a What-If simulation
exercise, is most commonly used by financial analysts to predict the outcome of a specific action
when performed under certain conditions.

Financial Sensitivity Analysis is done within defined boundaries that are determined by the set of
independent (input) variables.

For example, Sensitivity Analysis can be used to study the effect of a change in interest rates on
bond prices if the interest rates increased by 1%. The “What-If” question would be:
“What would happen to the price of a bond If interest rates went up by 1%?”. This question is
answered with sensitivity analysis.

The analysis is performed in Excel under the Data section of the ribbon and the “What-if
Analysis” button, which contains Goal Seek and Data Table. These are both taught step by step
in our free Excel Crash Course.

Sensitivity analysis example

John is in charge of sales for HOLIDAY CO that sells Christmas decorations at a shopping mall.
John knows that the holiday season is approaching and that the mall will be crowded. He wants
to find out whether an increase in customer traffic at the mall will raise the total sales revenue of
HOLIDAY CO and if so, by how much.

The average price of a packet of Christmas decorations is $20 and during the previous year’s
holiday season, HOLIDAY CO sold 500 packs of Christmas decorations, resulting in total sales
worth $10,000.

After carrying out a Financial Sensitivity Analysis, John determines that a 10% increase in
customer traffic at the mall results in a 7% increase in the number of sales.
Using this information, John can predict how much money company XYZ will generate if
customer traffic increases by 20%, 40%, or 100%.

Based on John’s Financial Sensitivity Analysis, these will result in an increase in revenue by
14%, 28%, and 70%, respectively.

Learn how to build a table like this in our Free Excel Crash Course!

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Sensitivity Analysis vs. Scenario Analysis

It is important not to confuse Financial Sensitivity Analysis with Financial Scenario Analysis.
Although similar to some degree, the two have some key differences.
Sensitivity Analysis is used to understand the effect of a set of independent variables on some
dependent variable under certain specific conditions. For example, a financial analyst wants to
find out the effect of a company’s net working capital on its profit margin. The analysis will
involve all the variables that have an impact on the company’s profit margin such as the cost of
goods sold, workers’ wages and managers’ wages, etc. The analysis will isolate each of
these fixed and variable costs and record all the possible outcomes.

Scenario Analysis, on the other hand, would require the financial analyst to describe a specific
scenario in detail. Scenario Analysis is usually done to analyze situations involving major shocks
such as a global market shift or a major change in the business.

After specifying the details of the scenario, the analyst would then have to specify all the
variables, so that they align with the scenario. The result is a very comprehensive picture of the
future (a discrete scenario). The analyst would know the full range of outcomes, given all the
extremes, and would have an understanding of what the outcomes would be, given a specific set
of variables defined by a specific real-life scenario.

Advantages of Financial Sensitivity Analysis

There are many important reasons to perform sensitivity analysis:

 Sensitivity Analysis adds credibility to any type of financial model by testing the model across a
wide set of possibilities.
 Financial Sensitivity Analysis allows the analyst to be flexible with the boundaries within which
to test the sensitivity of the dependent variables to the independent variables. For example, the
model to study the effect of a 5-point change in interest rates on bond prices would be different
from the financial model that would be used to study the effect of a 20-point change in interest
rates on bond prices.
 Sensitivity analysis helps one make informed choices. Decision-makers use the model to
understand how responsive the output is to changes in certain variables. This relationship can
help an analyst in deriving tangible conclusions and be instrumental in making optimal decisions.

What are sensitivity analysis best practices?

#1 Layout in Excel
Layout, structure, and planning are all important for good sensitivity analysis in Excel. If a
model is not well organized both the creator and users of the model will be confused and the
analysis will be prone to error.

The most important points to keep in mind for layout in Excel include:

 Place all assumptions in one area of the model

 Format all assumptions/inputs in a unique font color so they are easy to identify
  Think carefully about what to test – only the most important assumptions
 Understand the relationship (correlation) between dependent and independent variables
(linear, nonlinear?)
 Create charts and graphs that allow users to visualize the data
 Create a separate area for the analysis using grouping (see example below)

#2 Direct versus indirect methods

The direct method involves substituting different numbers into an assumption in a model.

For example, if the revenue growth assumption in a model is 10% year over year (YoY), then the
revenue formula is = (last year revenue) x (1 + 10%). In the direct approach, we substitute
different numbers to replace the growth rate, like 0%, 5%, 15%, and 20% and see what the
resulting revenue dollars are.
The indirect method (as shown below) inserts a percent change into formulas in the model,
instead of directly changing the value of an assumption.

With the same example as above, if the revenue growth assumption in a model is 10% year over
year (YoY), then the revenue formula is = (last year revenue) x (1 + 10%). Instead of changing
10% to some other number, we can change the formula to be = (last year revenue) x (1 + (10% +
X)). Where X is a value contained down in the sensitivity analysis area of the model.

learn how to do this step by step launch our sensitivity analysis course now!

#3 Tables, charts, and graphs

Sensitivity analysis can be challenging to comprehend even by the most informed and
technically savvy finance professionals, so it’s important to be able to express the results in a
manner that’s easy to follow.

Data tables are a great way of showing the impact on a dependent variable by changing up to
two independent variables. Below is an example of a data table that clearly shows the impact of
changes in revenue growth and EV/EBITDA multiple on a company’s share price.
Tornado Charts can be a great way of showing the impact of changes to many variables at
once. They are called Tornado Charts because they are sorted from the most impactful to least
impactful in a way that shapes the chart like a tornado cone. To learn how to build these charts,
launch our sensitivity analysis in Excel course now!
Related articles and guides
Thank you for reading this guide to sensitivity analysis. CFI is the official global provider of
the Financial Modeling and Valuation Analyst (FMVA) designation, a leading credential for
financial analysts. To learn more about financial modeling, these free resources will be helpful:

 Scenario Analysis
 Analysis of Financial Statements
 DCF Modeling Guide
 Financial modeling best practices

Financial Modeling Certification

Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s
online financial modeling classes!

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