Even at the best of times, the financial markets can be a minefield that is riddled with uncertainty and surprises. It would be foolhardy to presume even the best made business decisions will work out as planned.
This is even truer when it comes to investments as there are multiple influencing factors that can impact your portfolio. Varying market conditions, the shifting economic landscape and other unforeseen developments can all upset even a well constructed investment basket. This is where a proven tool like scenario analysis becomes quite relevant and knowing how to make it perform can be invaluable.
- What is Scenario Analysis?
- Why do Businesses Need Scenario Analysis?
- Benefits of Performing Scenario Analysis
- How Scenario Analysis Works
- How to Perform Scenario Analysis
- Drawbacks of Performing Scenario Analysis
What Is Scenario Analysis?
Scenario analysis is a comprehensive estimation of all eventualities faced by a business in the future. This useful tool helps management draw up an exhaustive list of variables that can affect business outcomes, assess the potential damage they can cause, size up the risks and evaluate plans accordingly and make more informed decisions.
As a prediction tool to evaluate potential developments and estimate their outcomes and impact on a business over a period of time, scenario analysis is widely used by organisations worldwide.
This process can be applicable and relevant in all industries and in all spheres of life too. There is no telling what kind of unfavourable turn of events can happen, whether in the corporate world or in a personal setting. It is important to be prepared for worst case scenarios and making a studied assessment of future events and their impact can be hugely helpful.
In the world of investments, scenario analysis refers to the process of making an estimate of the behaviour of a portfolio over time with the assumption that there will be external developments impacting its performance. It is a methodical approach to analysing and estimating the effects of unforeseen and unfavourable changes to the valuation of investments.
Why Do Businesses Need Scenario Analysis?
Globally, the business landscape is becoming more and more competitive with constantly evolving technologies, tighter regulations and enhanced consumer expectations.
In such conditions, companies need to actively engage in assessing possible developments and analyse the future scenario of their business. It is important to anticipate the potential impact of any oncoming changes and be ready with back-up plans.
Nothing demonstrated the criticality of scenario analysis to businesses like the COVID pandemic that hit the world in 2020 and continues to rage in 2021. Despite enterprises having been using this tool, none would have expected the repercussions of COVID-19 to have brought the world to a standstill. Many sectors were forced to suffer greatly while many companies even wound up or pared their size drastically.
But this may well be a wake-up call for companies to factor in a similar eventuality in the future while making business plans and preparing for risks and opportunities.
Benefits of Performing Scenario Analysis
✅ Catalysts for right decisions
Decision making is a constant process in any business environment and this needs to be taken with as much knowledge of the present as foresight about the future. To ensure, any plans are taken with the right decisions, it is critical for them to be thought through for the future. This is when scenario analysis comes in handy with decision making becoming easier and better using its results.
✅ Indicators to size up impact of unforeseen developments
When managers work with scenario analysis, they are being extra cautious and look harder to discover potential hurdles and minefields that can disrupt or even destroy their plans. This attitude of erring on the side of caution prepares them for worst case scenarios and mitigating risks.
✅ Guides to discover future opportunities
Scenario analysis, as a process, has the unique ability to force managers into taking a holistic view of not just looking for risks and threats but also for opportunities that could lie ahead. When looked at through the prism of caution, the possibilities that still crop up can be worth looking at from a business development standpoint.
✅ A planner for the company and investors alike
With a well-constructed scenario analysis, besides understanding the risks they should anticipate, investors also get an idea of the kind of returns they can expect. This helps for planning the scope of additional investments for the future too.
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How Scenario Analysis Works
The efficacy of scenario analysis is purely dependent on the quality of the inputs used to assess the future.
The starting point to scenario analysis is identifying an event in the future and estimating the business impact it could harbour. The scenario is assessed for both the best and the worst case possible. At this stage, assumptions are made on the possible effects that the various aspects of this event could have on the business.
How to Perform Scenario Analysis
The steps to perform scenario analysis are mentioned below.
Define the challenges vis-à-vis the business plans
The starting point for any scenario analysis is to define the challenges faced in context of the plans laid out by the company. Once the timelines and the goals are mapped out and the potential problems defined, there is clarity to start the analysis itself.
Map out the project
The next step is gathering all the information needed at a macro level to map out the project. This contains all assumptions and variables, list down the factors and dependencies, trends and uncertainties, and have a broad road map of the exercise itself.
Create a list of variables
It helps to make a clear and comprehensive list of all variables that have the potential to affect the plan. This list should contain both the known and unknown and carry as much texture and information as possible to support the creation of possible scenarios. The more complete and well fleshed out this list, the sharper will be the understanding of the certainties and uncertainties that lurk ahead.
Develop possible scenarios
Here, the idea is to create a set of scenarios depicting possible future states the business could find itself in. Having these mapped out in a proper, customised template puts the inputs in perspective for a review. The changes in the industry, in the economic landscape and any other varying factor are envisaged. This can include any change in customer behaviour, pricing variations, economic developments like inflation and interest rate movements and other influencing factors in business.
Usually, there are different sets of scenarios taken into account to cover the gamut of probable changes. A best and a worst case scenario are lined up alongside a base case too and these should cover all the possible situations.
Understand the overall impact of variables on the scenario
With the various scenarios now listed and mapped out, it is down to an evaluation of both individual components and their overall impact. Here, the difference between the two commonly used tools – sensitivity and scenario analysis – also become apparent. While, with sensitivity analysis, only the variable wise impact can be measured, scenarios analysis takes a holistic view and helps understand the total effect of all variables.
Evaluate options and determine possibilities
With the results of the evaluation of the impact of the variables now ready, it is easier to draw up a list of possibilities that can be safely included in the plan. At this stage, it becomes possible to eliminate options that pose a potential risk and pick up only the ones that look safe.
Once the results are in and the various possibilities analysed in the context of the organisational and operation goals, it is easier to then go ahead with the implementation with more confidence and assurance.
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Drawbacks of Performing Scenario Analysis
❌ Quality of inputs
The one criticism of this tool is that it can only be as good as the quality of inputs. If the data and the information collected and included in the assessment are incomplete or incorrect, it can impact the analysis. This is especially true if historical data or those collected with limited expertise or diligence early on happen to be a major part of the data used.
❌ Quality of analysis
Likewise, if the analysis of the inputs also is substandard, the conclusions can be skewed and counterproductive. Even with correct data, there is a risk of the scenario analysis going awry should there be any bias or preconceived notions on the part of the analyst. The analysis can be effective only if objectivity is maintained during the process.
❌ Limitations of scope
Despite best efforts, an analysis may still not be able to cover all possible future scenarios. There can always be some unforeseen development that could come up. Also, even if a scenario is envisioned, it is difficult to correctly scope it completely to include every probability and outcome.
❌ Demands on the business
Scenario analysis, for all the benefits it holds out, is a process that will put significant demands on a business. It will take a considerable amount of time, effort and money to get a good job done and make sure it all pays off in the long run.
Scenario analysis can be a great tool for investors during their decision-making process, especially, when there are potentially favourable and unfavourable events that could impact them; however, the irony is that the analysis is only as good as the assumptions and inputs made.
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