Using Excel for Business and Financial Modelling, 3rd Edition

CHAPTER 11Stress Testing, Scenarios, and Sensitivity Analysis in Financial Modelling

Any good financial model will usually contain scenario and sensitivity analysis functionality, at least to some degree. Scenarios are an important part of financial modelling, and the reason we have left this to near the end of the book is that it is usually a task performed at the end of the model-building process. If the model has been properly designed using best practice, it is not difficult to add, edit, and change scenarios in the model.

Scenarios and sensitivity analysis are great ways to insulate your model from risk. What would be the absolute worst that could happen? If everything that can go wrong does go wrong, will my business/project/venture still be okay? There are usually effects and interactions between multiple variables that may change in the model.

Scenarios can assist with decision analysis. They are laid out in advance so that decision-makers can see the expected impact of each course of action. How close to reality these scenarios are really depends on the accuracy of the assumptions implicit in the model—but that's another story! (See “Document Your Assumptions” in Chapter 3.)

Scenario analysis is a very important part of financial modelling—in fact, in some cases, being able to perform a scenario analysis is almost the whole point of building a financial model in the first place! Many of the principles of best practice in financial modelling discussed in earlier sections ...