What is scenario analysis?
Scenario Analysis involves looking at a situation from a number of different perspectives or scenarios so that possible outcomes can be predicted. In finance it is the analysis of possible alternatives, outcomes and their possible effects. It provides a framework for managing risk and judging tradeoffs between options. The most common example concerns companies going public – the new company will have to have a strategy for good and bad performance going forward so they can maximize their success during both profitable periods and periods of loss. Scenario Analysis provides the opportunity to see into the future by posing “What if?” questions which help prepare for different outcomes that could happen. Scenarios tend to be used in conjunction with probability theory and decision analysis techniques such as expected value (EV) and utility maximization (U).
The scenarios employed in finance are typically classified into two types: qualitative scenarios that describe what might happen, without necessary analyzing the likely likelihood of the event occurring; and quantitative scenarios that attempt to estimate both likelihoods and associated economic impacts in addition to qualitative insights. Scenario analysis provides a means for dealing with uncertainty and risk, and since the Great Recession of 2007–08, its use has been encouraged by regulators as a tool to help improve decision-making.
When is scenario analysis useful?
Scenario Analysis is often used by decision-makers. Decision-makers are those who spend their time planning for the future, either in their roles as companies or individuals. For example, a company’s CEO will be presented with several potential products to help build the company’s market share. The CEO will likely try to find out what the demand for those products will be by looking at past sales trends, inventory numbers, and other factors which help create a prediction for future sales.
Scenario Analysis can also be used on a smaller scale – a homeowner might realize that a major life event, such as retirement or illness, could affect their ability to pay their mortgage going forward. A scenario analysis would consider the potential changes to the household budget if one spouse went on disability or if interest rates were higher or lower than they are now. The homeowner might also look at the potential benefit of selling their house and moving to a less expensive home in order to save money until retirement.
It is also important to note that scenario analysis is not perfect and there are many other methods available to help future proof your business. It is also important to note that the results of scenario analysis may not be accurate and there may be cases where you can develop a plan for a scenario and it never happens.
Advantages of scenario analysis
1. It allows you to identify gaps in your knowledge, so you can take action now so they don’t become a bigger problem later.
2. It helps to eliminate risks and manage risks by creating contingency plans.
3. It gives management the ability to make decisions faster, because they can take corrective action if they see something occurring that wasn’t predicted.
4. It allows you to make proactive decisions instead of reactive ones, which is more cost effective.
5. It allows you to create an appropriate plan for all possible scenarios. Many problems occur because the management team only considers the most likely scenario or multiple scenarios that are similar (typically considered as 3-5 scenarios). If another scenario does occur then they are unprepared to deal with it, which means their plans may fail. Scenario analysis ensures your management team will be prepared for any events that could happen in the future.
You can plan for any big events that might impact your business in the future. For example, you know when and if they occur, what actions you will take to prevent them from becoming a bigger problem. This is because it gives your staff the opportunity to imagine each scenario and plan for each possible outcome. You aren’t making assumptions based on what has happened in the past. There may be nothing to base your strategy on if there is nothing to compare it with.
Disadvantages of scenario analysis
It can be time consuming and expensive. It may take weeks or months to identify all possible scenarios, and then more time to create contingency plans for each one of them. It also takes money to hire consultants or do research, which could be put towards other areas of your business if not needed. The cost involved should be weighed up against other costs that could occur if you aren’t prepared for certain events that could impact your business.
Scenario Analysis is used mainly by people making financial decisions who want to plan for the best and worst that could happen. Scenario Analysis can help you not only anticipate what could happen but also prepare for it, which could mean the difference between success and failure in your business strategy. If you don’t have good information about your business, your competitors, and your environment it might be difficult to develop scenarios. If you don’t know much about the potential risks, or opportunities that could impact your business in the future then it will be difficult to create effective scenarios. For this reason scenario analysis is often used when firms are in an early stage of development, when they are in an industry that has little stability or in times of change in the market. If you know what to expect in the future then you can better ensure your plans will be appropriate. Firms and business managers that require the services of Scenario Analysis Specialists to help them make better financial decisions can look to Fintalent, the hiring and collaboration platform for Tier-1 M&A and Strategy Professionals, for all of their freelance Scenario Analyst Consultation needs.