How a sensitivity analysis can toughen up your financial forecasting

June has been all about forecasting so you can meet your business goals. While forecasting can yield huge dividends, you probably noticed a thread of uncertainty in some of the assumptions.

A sensitivity analysis is a way to overcome those issues.

No, a sensitivity analysis isn’t about discovering your inner self or coming to grips with daddy issues.

It’s about testing forecasts with “what ifs” so they can identify weaknesses and verify strengths, all of which lead to a better business outcome for you.

So today, we’ll talk about what a sensitivity analysis is, who needs it, and how to get help creating one.

Let’s go!

What’s a sensitivity analysis?

A sensitivity analysis is a process determining how variable changes can impact a desired outcome.

For example, let’s say you own several convenience stores, all with fuel pumps. You’ve done a revenue analysis.

Because fuel is a volatile commodity, you can do a sensitivity analysis to see if changes in gas prices will impact how much people spend on food and beverages inside each store.

It’s simply showing how sensitive your revenue assumptions are based on a key variable, the price of fuel.

But you don’t have to relegate a sensitivity analysis to just revenue. It can be applied to any number of financial forecasts, including cash flows and profits.

Who should do a sensitivity analysis?

Volatile industries that work with commodities are good candidates for sensitivity analysis. Sudden price fluctuations in one area, like fuel, can significantly impact your bottom line.

If your business is weather-dependent, like agriculture or construction, a sensitivity analysis can help provide insight into scenarios when Mother Nature isn’t cooperating.

Startups are another candidate because there is little historical data to go on, and variables are more difficult to pin down.

How is a sensitivity analysis performed?

Honestly, with a lot of help.

Unless you are highly experienced in your business and the variables are relatively few, you’ll want to employ the help of a CPA.

But you can’t just toss the job on an accountant’s desk and walk off. They’ll need input on your key variables. Even if your CPA is intimately familiar with your industry, your variables may differ.

You’ll also need to provide them with likely scenarios that could impact your business.

They will probably provide you with some, as well. Having an optimistic, realistic, and pessimistic analysis for each variable is best.

If your analysis is simple, like a single variable in the convenience store example, it can probably be done on a spreadsheet.

But most are more complex (and robust) so if you plan to DIY this project, check out this article for a deeper dive on how to do it.

Once the analysis is complete, it’s time to do something with the data.

Using the results

First, evaluate how changes in your key variables will affect your desired outcome. Then, develop contingency plans.

If our convenience store owner sees a drop in gas prices, more people may travel and buy from his inventory. That’s great!

But he’ll need a plan to pay for additional inventory and ensure his suppliers can keep up with demand to maximize profit.

You’ll also need to constantly monitor and update the analysis. Sudden changes in market conditions (think COVID-19 or hurricanes) will force you to adapt and evolve.

The Bottom Line

Financial projections can be a fantastic tool to help you take advantage of opportunities and avoid big problems.

But they must be tested—the more rigorous the testing, the more effective the projection.

So, take some time to learn more about sensitivity analysis and consult your CPA about getting one done for your financial projections.