Sensitivity analysis is an integral part of financial modeling and business planning. It helps startups analyze how different values of an independent variable will impact a dependent variable under a given set of assumptions.

However, many startup founders are unfamiliar with sensitivity analysis and its potential benefits. As a result, they often make decisions without considering how sensitive their business plans are to changes in key assumptions.

The guide will introduce startup founders to sensitivity analysis and its usage. Keep reading to learn more.

What Is Sensitivity Analysis?

Sensitivity analysis studies how the uncertainty in the output of a mathematical model or system (numerical or otherwise) can be divided into different sources of uncertainty. A model is said to be sensitive to an uncertain parameter if a small change in that parameter results in a significant change in the model output.

In the context of financial modeling, sensitivity analysis shows how the value of a financial model output changes in response to changes in certain inputs, known as drivers. Some drivers include interest rates, commodity prices, exchange rates, and company-specific variables such as revenue growth.

How Does Sensitivity Analysis Work?

Sensitivity analysis is also often termed a what-if analysis. The name is apt since it is often used to analyze what would happen to the results of a given decision if one or more assumptions underlying the original decision were changed.

An early-stage startup can use sensitivity analysis in its financial models to do the following:

• Forecast: Since a startup is typically a high-growth company, its financial situation can change rapidly. By plugging in different values for key drivers of revenue and expenses, a startup can get a better idea of how its financial situation might change in the future.
• Plan for Different Outcomes: A startup can use sensitivity analysis to see how different changes in assumptions might affect its financial forecast. What if the marketing campaign doesn’t deliver the expected results? What if a government regulation impacts business processes? It can help the startup plan for different outcomes and make more informed decisions.

So how does this work? The basic idea is to vary one or more inputs to a model and see how the outputs change. For example, in a financial model, the inputs might be assumptions about revenue, expenses, and interest rates. The outputs might be profit, cash flow, or return on investment.

To do a sensitivity analysis, you must choose the inputs you want to vary. Then, you need to decide how much you want to vary them. For example, you might want to increase revenue by 10% and decrease expenses by 5%.

Once you’ve chosen the inputs and the amount you want to vary them, you can run the model with the new inputs and see how the outputs change.

Benefits of Sensitivity Analysis

Sensitivity analysis can help startups make their financial models more dynamic. Here are some benefits of sensitivity analysis.

Helps Determine Impactful Variables

When inputs in a financial model are changed, not all changes will have an equal impact on the model’s results. Sensitivity analysis can help determine which inputs impact the model most. It can help startups focus on the most important inputs and make more accurate predictions.

Allows for Reliable Predictions

Since sensitivity analysis considers multiple scenarios, it can give startup founders a more accurate idea of what to expect. For instance, what will happen if the number of customers decreases? What if costs go up?

Making reliable predictions is imperative for startup success. It also helps create pitch decks that convey the most accurate story to potential investors.

Creates a Cohesive Financial Model

No investors will be confident in your business if you only present a single scenario. They want to see best and worst-case scenarios. They want to know that you’ve thought about the potential risks and rewards of your business.

Sensitivity analysis helps startups create a cohesive financial model by running multiple scenarios. In addition, it gives startups a well-rounded view of their business, which is essential for attracting investors.

Limitations of Sensitivity Analysis

While sensitivity analysis is a powerful tool, it does have limitations. Here are some of them.

Doesn’t Account for the Probability

A sensitivity analysis shows you how far a variable must change to give a certain output. However, it doesn’t consider the probability of this change occurring.

For example, a sensitivity analysis might show that a 10% increase in the price of a product will lead to a 5% decrease in demand. However, there is no indication of how likely this scenario is.

Is Not Relative

In most cases, a sensitivity analysis only focuses on a single variable. However, in real-world scenarios, variables are interconnected.

For instance, inflation is connected to wages, which is, in turn, connected to the cost of living. However, a sensitivity analysis of inflation would not take this into account. It would only focus on the effects of inflation without considering the other variables. That can lead to oversimplified results that don’t reflect reality.

Requires Detailed Data

To be effective, a sensitivity analysis requires detailed data. It can be difficult and time-consuming to obtain so much information.

Should You Include Sensitivity Analysis In Your Financial Model?

As a startup, you must look for ways to optimize your financial model. One way to do this is through sensitivity analysis, which allows you to see how changes in certain variables impact your business.

Therefore, you should include it in your financial model. But then again, a sensitivity analysis for a startup is different from that of an established business. Thus, you must take a custom route rather than a generic approach.

Incorporate Sensitivity Analysis in Your Custom-Made Financial Model

Customized financial models are more comprehensive than generic ones since they consider your specific business situation and goals. At Numberly, we create financial models tailored to your level of maturity and financial situation.

Since our models forecast cash flow requirements well in advance, there’s no room for surprises. Plus, our models answer all the ‘what if’ questions stakeholders may have about your business.

The dashboard has all the ready-to-go KPIs that you can present to potential investors to show your company’s progress. Schedule a 30-minute free call with our experts to learn more about how we make financial modeling a breeze for early-stage founders.