Scenario analysis

What it means

Scenario analysis is a planning method in which, instead of one plan, a company prepares several coherent versions of the future, usually a base, an optimistic and a pessimistic scenario. Each scenario changes several assumptions at once, such as revenue, input prices, exchange rates and interest rates.

Unlike sensitivity analysis, which changes one variable at a time and examines its effect, scenario analysis captures the connections between them. In a downturn, revenue usually falls, receivables take longer to collect and credit becomes more expensive all at once.

The output is financial statements, cash flow and ratios for each scenario. Management sees not only the expected result but the range within which it may move, and can prepare for a worse outcome before it happens.

How it works in practice

When preparing a budget with clients we also build a pessimistic scenario alongside the base case. It shows how much cash the company would need if revenue fell by a fifth and whether its existing credit facility would be enough.

For start-ups we use scenarios to calculate runway: how long the company will last if growth comes later or the funding round is delayed. For investment decisions and DCF valuations they show how much the project’s value depends on the assumptions.

For each scenario we also set out responses: what the company will do if the pessimistic version materialises, such as postponing an investment, cutting costs or asking the bank to defer repayments. Scenario analysis thus becomes part of risk management.

What to watch out for

Scenarios are useful only if they are realistic. A pessimistic scenario just five per cent worse than the base case shows nothing. We recommend drawing on real past events, such as the downturn during the pandemic or the energy crisis.

Too many scenarios give an impression of precision but in fact overwhelm. Three well-thought-out versions with clear assumptions and responses give more than dozens of variants nobody can follow.