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Sensitivity analysis

If a manager is given the ability to produce a range of possible outcomes in response to the request for an estimate this will reduce the worry in the mind of the manager who must produce the estimate. If the range reveals that most favorable estimate produces a favorable outcome, still that is no worry. But if the least favorable estimate produces and unfavorable outcome, there is indeed the great need to worry because if this least favorable, bottom side estimate should come to pass then the firm could be in ruble. Therefore a part of the process of forecasting must be to highlight any such extremity critical or sensitive areas by seeking to answer a series of what if.....? questions e.g., what would  happen to profitability and liquidly if sales fell by 25% what if customers took three months to pay their accounts instead of one month ? And so on. This aspect of forecasting is called sensitivity analysis.

The object of sensitivity analysis, by iterative combination of all possible outcomes within the range of estimates submitted, is to isolate within the forecast those critical factors or by variables.  Variations in which are likely to have the most critical impact upon the financial fortunes of the firm. Management attention must hen be focused on these key variables because these are the killer areas; area what it is worth seeking more information in order to improve the quality of the best guess estimate; areas where some form of insurance might be sought. areas where subsequent vigilance in the monitoring both of forecasting assumptions and of actual cash flows must be strongest in order to give the earliest warming of an impending financial crisis.

It must be stressed that sensitivity analysis is a relatively simple and unsophisticated concept. All it implies is that several  forecasts are produced form a range of estimates fed into the process instead of producing one forecast are produced form a range of estimates fed into the process instead of producing one forecast form single point estimates. The firm is thereby more easily bale to ascertain under what combination of circumstances it might be exposed to risks which it would prefer not to face. At the best these risks might represent a break in essential to the firm; worst they might represent insolvency.

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