How to Use Scenario Analysis (With Definition and Examples)
By Indeed Editorial Team
Published 16 October 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Many financial professionals spend time assessing potential risks for a company or organisation to help business leaders make informed decisions. One method for analysing risk is scenario analysis, which involves creating potential scenarios and developing a contingency response. If you're a financial professional, you can benefit from learning about how to conduct this type of risk assessment. In this article, we define scenario analysis, explain how to use it, discuss why it's important and provide examples.
What is a scenario analysis?
Scenario analysis is a method used by financial professionals in businesses and organisations to anticipate future events or changes, reduce uncertainty and develop planned responses to these potential changes. Usually, a company plans to invest resources to successfully analyse and respond to potential risks. This method can help financial professionals perform a risk analysis to better understand their company's finances. Typically, the goal of this analysis is to understand possible changes in cash flow and business valuation.
How to use scenario analysis
Many professional sectors employ this method for analysing financial risk. Regardless of where you work, you can use the scenario method for analysis if you're a finance professional. If you want to use scenario analysis, consider following these steps:
1. Ask questions
Before you create any scenarios, it's important to ask questions. The goal is to identify the scope of future issues and determine the limits of each potential uncertainty or change that may arise. Asking questions about the current financial market or the company's current budget can help you determine what type and how many scenarios to develop in your analysis. Here are a few questions you might ask:
What's the goal?
What's the desired outcome?
Does this outcome have a timeline?
What external factors could impact the timeline?
What internal factors could impact the timeline?
2. Challenge past experiences
This type of risk analysis requires financial professionals to challenge past experiences and imagine new scenarios. For example, if a project manager had a faulty project last year, this doesn't mean that the same project is going to be faulty this coming year. Rather than relying solely on past experiences, it's important to challenge your assumptions and think creatively when using this method so you can think of new uncertainties that could arise.
3. Gather data
As you begin the process of analysing potential scenarios, gather all relevant data you may need. This includes key factors, such as market trends, project budgets and cost of resources. During this process, you might begin to identify uncertainties that may appear in your scenarios. An uncertainty includes anything that poses a risk to the project. You might use a structured data tool to keep your data organised throughout the process.
4. Distinguish certainties from uncertainties
After gathering data, you can begin to distinguish certainties from uncertainties. Some certainties might include the pre-determined budget or the number of staff members available for a certain project. Uncertainties might include a drop in the stock market or a loss of business that leads to fewer available resources. During this step, you can also identify any areas where you might miss a potential risk. Some factors to consider include resources, time management, market trajectory and the projected success of the business.
After distinguishing what obstacles are certainties and which are uncertainties, you can list the uncertainties from highest to lowest priority. If your project involves gathering new investors, you might prioritise a stock market scenario, as this could influence potential investors' willingness to commit to your business. Creating a list of priorities helps you define which scenarios would have the most impact on a project so you can plan an appropriate response.
5. Determine the number of scenarios you need
After you have a list of priorities, you can determine the number of scenarios you need. Typically, financial professionals create a best-case, worst-case and a few other scenarios to be as prepared as possible. You can use the list to guide the number of scenarios, and it's best to start with the top priority to create your first scenario.
Each scenario combines an uncertainty with your desired outcome so you can effectively prepare for the possibility that some uncertainties may occur during the project. There are different variables in each scenario, which is why it's beneficial to create more than one. There are a variety of different scenarios you might create. Here's a list of the types of scenarios you might develop for analysis:
Evolution: This scenario occurs when everything happens as expected, with no uncertainties occurring or interfering with the outcome.
Revolution: This scenario occurs when something disrupts or changes the situation drastically. This might occur in a volatile market, like real estate.
Cycles: This scenario occurs when the situation is cyclical. This may occur on a university campus where a new school year starts each fall.
Infinite expansion: This scenario occurs when the situation is consistently developing at a fast pace. This might occur in a situation with many moving parts.
Generational: This scenario occurs when there are changes in culture, demographics or trends. This could occur after a political or social movement.
6. Use your scenarios to plan a response
Once you develop a few scenarios for your situation, you can develop thoughtful responses. Each scenario presents a different route to the same outcome, so it's best to create responses that specifically address the uncertainties or variables in each of your scenarios. For example, imagine the outcome is to increase property sales, so your worst-case scenario includes a downturn in the real estate market. You can create a response that addresses this downward trend and includes a plan for continuing to sell properties.
Plan a response to each scenario that includes specific details about what steps to take in the event of the scenario occurring. You can get input from others to create a holistic response that considers every possibility. Then, you can save this response for the unlikely event that the scenario occurs during the project.
Why is this method of testing important?
Here are a few reasons why this method for testing is important and beneficial:
Keep stakeholders informed
Stakeholders are an important form of financial and business support for a company because they provide investment funds. Performing an analysis of scenarios allows companies to inform stakeholders of the company's financial health and valuation. This keeps stakeholders informed and allows them to understand the future finances of a company.
Attract new investors and partners
If a company is looking to attract investors, it may use this method to show positive growth, which can officer financial benefits for investors. Typically, these include the best and worst probabilities of working with an organisation, which can help an investor make an informed decision. After reviewing the analysis, they can decide if they want to invest in a company.
Safeguard against potential loss
Another benefit of using this method is that it can help a company be proactive and safeguard against a potential loss. By planning, they can anticipate situations and events that may lead to negative outcomes. Since this analysis looks at what is likely to occur, it helps organisations allocate resources more effectively.
Group thinking occurs when everyone begins to think alike, creating an obstacle for new ideas to be heard. When you use this method for risk analysis, you can help protect the organisation against groupthink because multiple scenarios can lead to a similar outcome. This provides several opinions to the group so people can share how they feel about each one.
Use these examples of scenario analyses to help you create your own:
Here's an example to improve your understanding:
Tim's Technologies just created an automatic window cleaner that sends notifications to users' phones and smartwatches when they need to add more cleaning liquid to the device. The company wants to determine if the market might like its product and decides to conduct an analysis using scenarios. They examine a variety of independent variables to see how they might change the outcome.
One factor Tim's Technologies looks at is whether its competitors offer a similar product. When reviewing this, they see if other technology companies offer similar products, their number of products sold may decrease. This allows Tim's Technologies to come up with a strategy for how they can attract more consumers to their product instead of their competitor's product.
Here's an example regarding changes in the cost of raw materials:
Avant Enterprises is considering whether to open a new office building next year. They conduct an analysis using scenarios to see what may occur if the cost of raw materials went up. They also examine the business demand for more office space in that area.
In one of their scenarios, the demand for office space decreases due to more people working from home, which would be a worst-case scenario. In a best-case scenario, the price for raw materials may decrease due to a partnership with a supplier. After reviewing some more scenarios, Avant Enterprises decides to build a new office.
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