Scenario Modeling – Everything you should know
The purpose of this article is to give you a detailed understanding of scenario modeling.
You probably know that the business environment is dynamic and unpredictable. Well, scenario modeling is a technique used in risk analysis and business forecasting. It is the prediction of possible futures under different scenarios, often with probabilities given to the different outcomes. The main goal of scenario modeling is to help understand and speculate on future events or scenarios and forecast the various possible results. But, what exactly is scenario modeling? What are the benefits of scenario modeling? How to do scenario modeling? The purpose of this article is to give you a detailed understanding of scenario modeling.
In scenario modeling, various possible outcomes of a situation are identified and analyzed with respect to their relationship and impact on the overall outcome. These scenarios are then arranged into a sequence of decision points that represent the best possible decision paths for the company. With the help of scenario modeling, mergers, acquisitions, funding rounds, and strategic moves can be planned and executed in a precise and effective manner. Thus, scenario modeling is a comprehensive approach to the forecasting of the future and is most useful when there are multiple possible outcomes that need to be predicted.
What is financial modeling?
Financial modeling is a simulation of a financial activity in which the decision-making process is laid out using numerical estimates. It basically involves forecasting the future (assumptions) and modeling financial events to evaluate the outcome of those forecasts. In simple words, financial modeling is the process of developing a suitable model based on numerical data, historical data and other relevant information to predict the financial performance of an organization. Further, it implies the company analysis of the probable result and the effect of different variables on financial performance.
What is scenario modeling?
Scenario modeling is a technique of analysis and forecasting wherein all future probable scenarios are identified with respect to their relationship and impact on the overall outcome. During the decision-making process, scenario modeling can be used to help in the identification of risks and opportunities for the organization. From exit strategies to merger and acquisition, business planning, funding rounds, scenario modeling can be used to create a smooth transition during each event. As a result, businesses will be able to stay on course and prepare for any contingencies that may arise.
Types of scenario modeling
Now that we have discussed the basics of scenario modeling, let us go ahead and talk about the various types of scenario modeling. Here are the three main types of scenario modeling:
- Base scenario – A base-case scenario outlines the anticipated result and serves as the foundation for management’s goals. It acts as a reference point for decision-making, and its objectives are to set the tone and direction for the organization.
- Upside scenario – The upside scenario also known as the best-case scenario is a relatively optimistic future state, representing the most favourable outcome. It is usually the most important part of scenario modeling because it helps establish concrete goals.
- Downside scenario – The downside scenario or worst-case scenario is one of the most important parts of comprehensive scenario modeling. It is the most negative outcome of the business, and it helps organizations plan for contingencies. This can also be seen as a risk management tool.
Questions to ask when doing scenario modeling
Since scenario modeling is a process that needs to be followed in detail, it is important to follow up on the right questions. Some of the right questions in scenario modeling are as follows:
- What internal dependencies must be met in order to achieve this goal?
- How much time do we have to achieve the goal?
- What assumptions were made when this goal was chosen?
- What other constraints must be observed?
- What scenarios might present an obstacle to achieving the goal?
- What resources are needed to produce this result?
- Are there any external influences that might hinder the execution of this strategy?
- How does this decision affect other parts of the business?
- What are the financial implications of this strategy’s execution?
- What are the possible risks involved in this strategy?
Therefore, these questions form a framework that when followed correctly, will ensure that the right decisions are made and that the desired results will be obtained. As such, scenario modeling is a reliable and effective way of decision-making and analysis.
Benefits of scenario modeling
Scenario modeling is one of the most reliable and powerful tools in the business world. The following are the benefits of scenario modeling:
- Future plan – By setting objectives and timelines, it is possible to prepare for potential events. The key objective of scenario modeling is to predict the future and provide a framework for decision-making. This enables the organization to decide on an action that can be executed with ease.
- Realistic financial model – The purpose of scenario modeling is to create a financial forecast for the business that is based on real and concrete facts. With realistic financial models, it is possible to identify parameter values to prepare a realistic financial forecast, thereby allowing for a detailed analysis.
- Test assumptions – Scenario modeling enables the testing of assumptions. Since the future is considered to be uncertain, it is important to test all the assumptions of expected results. As a result, any incorrect or misleading assumptions will be identified.
- Risk and failure can be avoided – Scenario modeling helps organizations avoid potential failure and reduce the impact of risks on the business. This can be done by identifying various scenarios and their consequences in advance, thereby preparing for the worst-case scenario.
- Avoid potential losses – To ensure that the business remains sound and has healthy growth, scenario models are very useful. The analysis and evaluation of various risk factors and their probable outcomes can help in avoiding any possible losses or damage to the business.
Drawbacks of scenario modeling
There are several drawbacks of scenario modeling that need to be considered when applying this technique. Below are some of the most important drawbacks of scenario modeling:
- Require skilled person – Scenario modeling needs to be performed by a skilled person. This is because it is a complex and detailed process. As a result, organizations need to invest in training their employees on scenario modeling, so that they are able to perform this technique in an effective way.
- Unforeseen outcomes – Scenario modeling may have certain unforeseen outcomes that may pose obstacles in achieving the desired results. To avoid any unforeseen consequences and ensure success, it is necessary to examine all possible options thoroughly before making a decision.
- Unable to model every scenario – Scenario modeling is not a perfect science, and as such, it cannot model every possible scenario. As a result, the inevitable consequences may not be captured. It is necessary to apply scenario modeling in a strategic manner and be realistic with the result that is being sought.
Sensitivity Analysis vs. Scenario Analysis
Sensitivity analysis, it is a financial model that helps determine how changes in other variables, known as input variables, affect target variables. In other words, it is the analysis of how changes in input affect decision outcomes. It is employed in circumstances where one or more input variables are necessary.
While scenario analysis, in contrast, is particularly employed in financial models, where output variables are not dependent on the input variables in question. As a result, the main difference between these two analyses is that sensitivity analysis typically focuses on one variable that triggers a change in the output, while scenario analysis focuses on a number of variables that impact the output.
Example of scenario modeling
To better understand scenario modeling, let us look at an example. For instance, an institution seeks to improve student satisfaction while strengthening its financial viability. This necessitates that they look at various pricing methods such as tuition fees, inflation, and other aspects that might affect students. Further, the institution would establish its baseline before doing a compelling scenario analysis so it could compare various options and results.
To choose the optimal course of action, they must then calculate every situation that could occur. As a result, considering all possible outcomes ensures that the college makes the best decision possible which increases student enrollment and retention rates.
How to do scenario modeling analysis?
Now that we have a better understanding of scenario modeling, let us look at how to apply this in real life. As a business, the following are the steps that you need to consider:
- Collect and list all the assumptions – Before you can do scenario modeling, it is necessary to list all the assumptions that are based on both facts and estimates. This will help in identifying the various possible scenarios of future events.
- Put assumptions on a spreadsheet – Once the assumption is identified and listed, enter them into a spreadsheet. As a result, you will be able to examine various scenarios based on changing specified parameters.
- Build a section for live scenarios – The next step is to create a live scenario that addresses the current situation and foreseeable future. To do this, you will have to decide on what values to specify for each of the variables in that scenario.
- Test and create a scenario-based plan – After identifying all possible scenarios, it is then necessary to test each of these scenarios using a variety of tools such as financial models. As a result, you will be able to determine which is likely to occur and develop a scenario-based plan accordingly.
- Test implement analysis and adapt – It is necessary to test the scenario analysis in real life by implementing it over a period of time. This will help in identifying any potential issues that need to be addressed for better results. Further, the various possible outcomes are then analyzed, and it helps the organization make quick decisions.
Scenario analysis in Excel vs software
Is it better to do a scenario analysis in excel or software? Well, to carry out a scenario analysis in excel, you need to manually calculate all the probabilities, enter them in the appropriate columns, and then do a comparison between them and the final result. This is a time-consuming process, which involves several manual calculations and charting, and therefore can be a tedious task to carry out. However, with advanced technology, scenario analysis can be done using automated softwares that are available online. This integrated approach significantly reduces the manual work involved in scenario analysis, thereby making it an easy and effective process to perform.
Why is using software the best choice for scenario modeling?
Well, the business environment demands a fast and efficient approach to any business activity. Relying on traditional methods or tools may not be the right choice in this regard, hence it is important to consider using advanced software that integrates real-time scenario analysis. These softwares make scenario analysis an easy process, and they offer robust features that make it an effective option as well. That being said, it is important to note that the overall effectiveness of scenario analysis depends on the software that you choose.
How to do scenario modeling analysis in Eqvista software?
As you know, choosing the right software is one of the most important aspects that you need to consider before performing scenario modeling. There are multiple options available online, however, Eqvista offers advanced software for scenario modeling. It is a robust tool that makes scenario analysis an easy and effective process, and therefore it is one of the best choices available online. You will not just be able to analyze various scenarios effectively; it also allows you to produce high-quality reports as well. With Eqvista’s scenario modeling software, you get a complete package to carry out scenario analysis.
Conduct your scenario modeling with Eqvista!
Are you still looking for the best modeling software for scenario analysis? Confused by the wide range of options available online? Well, your search ends here! With Eqvista’s scenario modeling software, you will be able to carry out scenario analysis effectively. The team at Eqvista has invested years of their time and effort in bringing you this scenario modeling software that provides an easy, flexible and effective option for analysis. To know more about Eqvista’s scenario modeling software, you can get in touch with us today!