What-if analysis
1. What-if analysis
Welcome back! In this chapter we'll review the basics of what-if analysis.2. What is what-if?
What-if analysis, also called scenario analysis, evaluates different scenarios to see what might happen. Imagine you have a small lemonade stand business, and you want to figure out how to make more money. You can use what-if analysis to explore different strategies. You might ask: "What if I raise the price of my lemonade by 50 cents" or "What if I offer a discount to customers who buy more than one cup?" By thinking about these different what-if scenarios, you're exploring various options and their potential outcomes, which helps you make informed decisions about how to run your business.3. What-if analysis in financial models
Financial models are essentially big what-if analysis engines, since they use input variables to determine an output, if we change one assumption, the entire model could change. This makes asking what-if questions very easy in financial models.4. Types of what-if analysis
There are two main types of what-if analysis. The first we've already talked about, scenario analysis, which analyzes one or more variable changes at a time. This is useful in analyzing a specific scenario.5. Types of what-if analysis
The other type of what-if analysis is sensitivity analysis. Sensitivity analysis evaluates the performance of a dependent variable given a range of inputs. This is similar to scenario analysis in that they both analyze how a dependent variable will react to certain inputs. However, scenario analysis is specific to a certain "scenario", while sensitivity analysis is more open-ended because it gives a range of inputs and values. Put another way, scenario analysis is like throwing a single dart at a dart board, whereas sensitivity analysis is like throwing bunch of darts at the same time to see where they'll land.6. Sensitivity table
Often, sensitivity analysis is presented in a table with conditional formatting that highlights the values from highest to lowest. Here is an example of the price sensitivity of supply and demand. Supply and demand are the independent variables labeled on the axes, and the price is the dependent variable, which holds the values in the table. It may look overwhelming at first, but it's simple once your eye is adjusted. Imagine that the units are for packs of bubble gum.7. Sensitivity table
Supply can be between one-thousand and fifty-thousand packs of bubble gum.8. Sensitivity table
The same goes for demand.9. Sensitivity table
To read the table, first look at the column. Here the demand is 3,000. So the analyst will see all the possible prices when demand equals 3,000 packs of bubble gum.10. Sensitivity table
Likewise, the highlighted row shows all the listed prices when the supply is 3,000 packs of bubble gum.11. Sensitivity table
So now the analyst can pick a certain row and column to understand how the value changes. For example, when supply and demand equal each other, the price is 5 dollars.12. Sensitivity table
However, when there is a shortage, and demand is 5,000 while supply is only 1,000, the price skyrockets to 25 dollars! This is why sensitivity tables are so useful; they display a wide range of outcomes that allow the analyst to understand how the inputs impact the dependent variable.13. Let's practice!
Hopefully this topic didn't make you too sensitive. Let's move on to some practice!Create Your Free Account
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