What is Scenario and Sensitivity Analysis?
Scenario and Sensitivity Analysis is a method to forecast the impact of changes in key assumptions on the projections.
This approach is essential as it helps to understand the potential variability in outcomes under different scenarios.
Example:
Imagine an online streaming platform, projected to attract 1,00,000 new users in free trial every year. The platform offers a premium annual subscription at ₹500 per user.
Initially, with a 5% conversion rate from free trial to premium tier, the Revenue Projection = 1,00,000 × 5% conversion × ₹500 = ₹25,00,000.
However, if the conversion rate changes — say it increases to 6% or decreases to 4% — the revenue projections would accordingly shift to ₹30,00,000 (1,00,000 × 6% × ₹500) and ₹20,00,000 (1,00,000 × 4% × ₹500), illustrating the impact of fluctuating conversion rates.
Significance:
1. Scenario Analysis: Involves examining various 'what-if' scenarios, such as what happens if the conversion rate increases or decreases.
This aspect of financial analysis helps businesses prepare for different potential futures.
2. Sensitivity Analysis: Focuses on understanding how sensitive the revenue projection is to specific variable changes.
In our example, the sensitivity is observed in the revenue change of ₹5,00,000 for every 1% variation in the conversion rate.
This analysis is crucial for identifying which variables have the most significant impact on the financial outcome and warrant close monitoring.