What does scenario analysis mean?
Scenario analysis is a process of examining and determining possible events that can take place in the future by considering various feasible results or outcomes. In financial investments, this process is typically used to estimate changes in the value of a portfolio, especially when there are unfavorable events that affect the market. Most business managers also use scenario analysis during their decision-making process to find out the best-case scenario as well as worst-case scenario while anticipating profits or potential losses. Individuals can use this process when they have a big investment coming up like purchasing a house or setting up a business. It is an analytical tool to manage present uncertainties rather than a predictive machine as it may catch only one possible future scenario.
What are the Three General Approaches Used in Scenario Analysis?
- Base case scenario – this is the average scenario based on management assumptions. An example – when calculating the net present value, the rates most likely to be used are discount rate, cash flow growth rate, or tax rate.
- Worst case scenario – considers the most serious or severe outcome that may happen in a given situation. An example – when calculating the net present value, one would take the highest possible discount rate and subtract the possible cash flow growth rate or the highest expected tax rate.
- Best case scenario – this is the ideal projected scenario and is almost always put into action by management to achieve their objectives. An example – when calculating the net present value, use the least possible discount rate, highest possible growth rate, or lowest possible tax rate.
What are the Benefits of Performing Scenario Analysis in Finance?
- Future planning – gives investors a peek into the expected returns and risks involved when planning for future investments. The goal of any business venture is to increase revenue over time, and it is best to use informed calculations when deciding to include the investment in the portfolio.
- Proactive – Companies can avoid or decrease potential losses that result from uncontrollable factors by being aggressively preventive during worst case scenarios by analyzing events and situations that may lead to unfavorable outcomes. As the saying goes, it is better to be proactive than reactive when a problem arises.
- Avoiding risk and failure – to avoid poor investment decisions, scenario analysis allows businesses or investors to assess investment prospects. It takes the best and worst probabilities into account so that investors can make an informed decision.
- Projecting investment returns or losses – the analysis makes use of tools to calculate the values or figures of potential gains or losses of an investment. This gives concrete, measurable data that investors can base the approaches they take for a better outcome.
What are the Drawbacks of Scenario Analysis?
Scenario analysis tends to be a demanding and time consuming process that requires high-level skills and expertise. Due to the difficulty in forecasting exactly what takes place in the future, the actual outcome may be fully unexpected and not foreseen in the financial modelling. It may be very difficult to envision all possible scenarios and assign probabilities to them. Investors must understand that there are risk factors associated with the outcomes and they must consider certain risk tolerance to be able to pursue a goal.
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