Whether the business environment is experiencing growth or there is economic turmoil, a successful business responds to any type of change. Financial forecasting is critical when times change. It is critical to have a linked 3-Statement Financial Model (Income Statement, Balance Sheet, and Cash Flow) before starting either type of analysis. A linked model will dynamically show how your assumptions affect your financial statements.
Scenario Analysis is the method of predicting the future value of an investment based on changes that may occur to existing variables. It requires one to explore the impact of different market conditions on the project or investment as a whole. This type of analysis is often used to estimate changes in cash flow or business value.
Typically, Scenario Analysis involves examining multiple inputs. For example, the user may consider accelerating growth through changes in production, price changes, additional financing, and capital expenditures.
Scenario Analysis is not about changing one variable (e.g., if the interest rate increases by 1% or the cost of raw materials increase by 10%). Scenario Analysis is about laying out the likely outcomes for wholesale changes in the business whether they are plans for expansion or planning for some type of disaster which results in a dramatic slow-down to the business.
At a minimum, one should consider a base case (current state), an upside case (best-case scenario), and a downside case (worst-case scenario). Additional cases can and should be considered, but an excessive number of cases can cause confusion.
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