What is Scenario Analysis and what is its importance?

The only thing certain in life is uncertainty. Scenario analysis is a powerful tool to handle business uncertainty in a scientific and appropriate manner. It is done by analyzing the future events and their impacts on the business and considering the alternative possible outcomes. Companies normally use a broad range of spectrum of future situations such as risks and cash flows to determine the scenario of the business at a future date. Therefore, it is an intriguing process for analysts because it offers an insight into the future.

What is Scenario Analysis?

Businesses need to consider various scenarios from good to best and from bad to worst about the future for their existence and profitability to remain intact. The businesses may consider several business scenarios, such as −

  • What would be the profitability if an economic slowdown hits the market?

  • How would the business suffer from a low value of investments in the stock market?

  • How can investments be secured from a potential loss due to a sudden impact on assets?

  • When should the business withdraw the money from the share market in the future?

Businesses usually do not take these considerations one at a time. They take all the risks and outcomes at once and perform the scenario analysis. After taking into consideration all the outcomes, a scenario planning may be done to save the business from uncertainty in the future.

Why Do Firms Need Scenario Analysis?

Businesses can face dire outcomes at times such as the global Corona pandemic in 2020. It was a sudden and unforeseen impact that changed the business basics altogether. Businesses need to stay prepared for such uncertain events and it has been realized one more time by businesses due to this pandemic. The pandemic taught the businesses that risks may occur at any time and businesses should plan for such crises before they occur.

Importance of Scenario Analysis

It has been illustrated by the global pandemic in 2020 that risks of numerous kinds may occur without showing any symptoms before the sudden impact occurs. It is therefore clear that a scientific and planned method has to be employed to handle such situations. Unless businesses prepare for such events and they save their resources to run the businesses in such environments, it may be hard for them to sustain the losses.

Scenario analysis and planning helps businesses plan and prepare for sudden impacts due to various reasons. It helps them stay afloat in a circumstance of uncertainty. Planning ahead also cuts the potential costs to a great extent, so businesses can use systematic scenario analysis to their advantage by resorting to it earlier.

It is the nature of saving businesses from uncertainty and future loss that makes scenario analysis and planning so important a tool in the world of finance.

Updated on: 24-Dec-2021


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