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Sensitivity Analysis

Mon, 29 July 2002

It is important to know how sensitive your forecast is to changes.
Sensitivity analysis looks at ‘what if?’ scenarios. What happens to your cash position, for example, if sales fall by 10%? What happens if your main supplier increases raw material prices by 12%? Sensitivity analysis is particularly used by financial institutions when considering propositions for a loan. If your business is particularly susceptible to small changes, then you probably do not have a sufficiently large profit margin. You will thus be less likely to receive the loan required. You may find it difficult to cut costs. You may not be able simply to increase prices to improve your margins - that might deter customers. Are there other ways in which you can push up the margins, eg by increasing output?
Having undertaken your sensitivity analysis, you may need to review elements of your forecast. Sensitivity analysis can help in making decisions. You may want to consider, for example, the effect of increased raw material, labour or overhead costs; of reducing prices, with constant volumes, to counteract competitors; or reducing volumes, with constant prices, due to over optimistic forecasts. Furthermore, if you are about to spend a large sum of money on equipment, you may want to look ahead several years, if at all possible.
Including a sensitivity analysis in your business plan will demonstrate that you have thought about some of the potential risks - and that is half way to avoiding them.

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