The environment of a business is very unstable, and it can change quickly due to the influence of external factors. These external factors can be anything from the change in a sales demand to the new application of a government policy that is not in the favor of business. This can result in the decrease in sales and maybe increase in costs. This will invariably reduce the profits of the company, and company will suffer losses. To prevent this from happening, the companies need to monitor the external environment continuously.
By keeping track of the changes in the external factors, necessary actions can be taken to prevent the losses. In order to keep track of the external changes, the entity needs to implement a method that will help it determine the sensitivity of its sales, costs and changes in its income patterns. This method is known as sensitivity analysis. The sensitivity analysis determines the changes in the quantifiable variables of the project to determine it viability.
The Purpose of Sensitivity Analysis
In a sensitivity analysis, only the unfavorable changes are accounted for to consider the impact of these changes on the profitability of the project. The sensitivity analysis serves following purposes:
· It helps in identifying the key variables that are major influence in the cost and benefits of the project. Demands, expenses, operating costs and legal costs, revenues and financial benefits are included in this stage.
· It also helps in determining the consequences of the unpleasant amends in these key variables.
· It also helps entities to assess whether these changes will affect the project decisions made.
· This method also helps in identifying and implementing the actions that will help mitigate these adverse effects.
Performance of Sensitivity Analysis
In order to optimize the utility of the sensitivity analysis, it needs to be carried out in a systematic manner. To optimize the performance, entities can follow following steps:
· Identification of the sensitive variables which affect the project decision
· Calculation of the effects of these changes
· Consideration of the variables in possible combinations that can be changed simultaneously
- Debt ratios
- Liquidity ratios
- Profitability ratios
- Asset management ratios
- Cash Flow Indicator Ratios
- Market value ratios
- Financial analysis
- Business Terms
- Financial education
- International Financial Reporting Standards (EU)
- IFRS Interpretations (EU)
- Financial software
Most WantedFinancial Terms
- Most Important Financial Ratios
- Debt-to-Equity Ratio
- Financial Leverage
- Current Ratio
- Interest Coverage Ratio (ICR)
- Solvency Ratio
- Break-even Point
- Debt Service Coverage Ratio
- Receivable Turnover Ratio
- Return On Capital Employed (ROCE)
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