Scenario based modeling is a process that is used to estimate changes in numbers such as those of the cash flow or balance sheet given changes in events, both favorable and unfavorable, that may impact organizational figures. The process involves examining possibilities that may take place in order to try to predict their potential impact on the numbers.
There is no one best example of scenario analysis, as this method can be used for a variety of functions. For example, an organization can use scenario analysis to determine the net present value of an investment they are considering under different inflation scenarios. Or, an organization may want to forecast different potential scenarios for the economy, and maybe even assign probabilities to different scenarios. The sky’s the limit when it comes to scenario analysis, but ultimately no matter what scenario you run, the goal is to make sure that optimal business decisions are being made.
When conducting a scenario analysis, finance professionals essentially generate different potential future states of the business. These states include assumptions regarding different prices, costs, customer metrics, interest rates, and other variables. When conducting scenario analyses, finance professionals typically start with three basic scenarios- the “base case”, “worst case”, and “best case” scenarios. The base case scenario is the average scenario. The worst case scenario considers the most severe outcomes, while the best case scenario considers the most ideal outcomes.
Scenario analyses can help organizations prepare for different potentialities and safeguard their business. The meaning of scenario analyses is that organizations can attempt to predict future outcomes of different decisions or factors, and in this way explore what might occur down the line.
A financial model is a tool that is built into spreadsheet software, oftentimes Excel, and is used by businesses to forecast their performance into the future. The financial forecast typically relies on historical performance as well as assumptions regarding future performance. Common financial models include the three statement model, discounted cash flow model, and merger model. All of these models dynamically link with formulas in Excel.
There are a few best practices you should consider when conducting scenario models. The first is to make sure that you’re utilizing various kinds of data. Draw upon information from various systems and processes to make sure that you have a holistic view of all your information. Next, while you should hope for the best, make sure that your scenarios take into account the worst case too. Consider all three scenarios: base, best, and worst.