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What Is A Sensitivity Analysis
A sensitivity analysis is a type of analysis of the impact of changes in independent values on dependent values based on certain assumptions.
In other words, when you do a sensitivity analysis, you’re looking to see how certain variables change or are affected by the change of other variables.
A sensitivity analysis can also be referred to as a “simulation analysis” or “what-if analysis”.
This type of analysis is quite common in business as businesses and analysts try to predict the impact the change of certain market conditions can have on their business.
In economics, this type of analysis is also used to see the overall impact of changes in certain variables on the economy.
For example, a business may perform a sensitivity analysis to assess the impact on its production costs as it increases or reduces production.
The idea is to see how the increase or decrease in production can impact their cost per unit.
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Why Perform A Sensitivity Analysis
Performing a sensitivity analysis is important for businesses of all sizes.
Fundamentally, businesses need to make decisions that benefit the company and ultimately bring value to the shareholders.
However, an important challenge for business owners and managers is to decide what decision to make in the current market condition that will allow for the best use of their time and resources.
To help companies decide, sensitivity analysis can be done to assess the impact of changes in certain variables that are influenced by changes in other variables.
For example, a company’s stock price can be influenced by changes in the company’s earnings, debt-to-equity ratio, or the number of shares outstanding.
A company’s profit margin will be impacted by the amount the company invests in capital assets.
The reason why a sensitivity analysis is important is that you can create a financial model where you change certain key inputs and assess the overall output.
The inputs are the independent variables and the output are the dependent variables.
Your objective is to see how changes in the independent variables can have an impact on the dependent variables.
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Pros And Cons of Sensitivity Analysis
There are many reasons why businesses and business professionals perform sensitivity analysis.
The main benefit of doing such a study is that you’re able to do a deep analysis of the variables that you’re studying.
For example, if you’re evaluating how your marketing strategy impacts your sales, you will have to carefully study your marketing strategies, understand the variables that you’re looking to manipulate, and understand how it affects your sales.
Another benefit to sensitivity analysis is that it helps company executives, board members, managers, business owners, and professionals make decisions.
If you had many possible options to choose from, you should choose the business option that generates the most value for your business.
With sensitivity analysis, you can rationally decide on a strategy and have a better understanding of the expected outcome.
On the other hand, a sensitivity analysis is not a magic crystal ball allowing you to make perfect decisions.
The quality of your analysis and decision depends on the quality of the data that you’re studying.
There’s a good old saying “garbage in, garbage out”.
This means that if your data is not good, the outcome of your analysis will not be good as well.
Another drawback is that the data used to perform a sensitivity analysis is either historical data or assumed data.
In both cases, the future may not end up following historical trends or your assumptions may be wrong.
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Sensitivity Analysis Example
Let’s look at an example of a sensitivity analysis to better understand the concept.
Let’s take a manufacturing company that is required to purchase raw materials to manufacture its goods.
The manufacturer knows that changes in the cost of raw materials will have an impact on its bottom line.
As a result, the manufacturer will do a sensitivity analysis to assess how changes in the cost of raw materials will impact is profitability.
For instance, it will consider incremental 1% changes in the price of raw materials that will impact its profitability.
If the company is forecasting that the price of raw materials is going up by 5% but that it will reduce its profitability by 8%, the company can immediately make key decisions to compensate for this expected reduction in profitability.
The company can consider finding efficiencies in its operations or changing suppliers to cut costs.
It can also consider increasing its prices to compensate for the expected reduction in its profitability.
As you can see, sensitivity analysis can help companies make better and more informed decisions about how to run their business.
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Sensitivity Analysis vs Scenario Analysis
What is the difference between sensitivity analysis and scenario analysis?
A sensitivity analysis is when you isolate certain variables and see how the changes of some of those variables impact other variables.
In the context of a sensitivity analysis, your main focus is on the variables that you have specifically identified.
For example, you may want to assess the impact of your online traffic on your conversions.
In this case, you are looking at how different traffic levels will impact your site conversion.
On the other hand, a scenario analysis is when you’re looking to create a comprehensive model to understand an overall outcome.
For example, you may want to perform scenario analysis on the consequences of a real estate crash on the economy.
Your objective is to simulate a real estate crash and see how the entire economy is affected.
To perform your analysis, you will use real-life variables for your model.
In essence, you’re creating a “scenario” and trying to see what the world will look like in that scenario.
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Takeaways
So there you have it folks!
What is sensitivity analysis?
In a nutshell, in business and corporate finance, a sensitivity analysis is a type of financial modeling where you are looking at a set of independent values that affect specific dependent values under certain conditions.
You can perform a sensitivity analysis on practically any aspect of your business to see how changes in certain variables affect other variables.
For example, you can perform a sensitivity analysis to see how the bond prices are impacted by changes in interest rates.
The idea is to see how every incremental change in interest rates impacts the face value of bonds.
For businesses to make sound business decisions, company managers and executives will typically study different alternatives so they can make the best possible decision based on the information available to them today.
Now that you know what a sensitivity analysis is all about and how it works, good luck with your research!
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