Sensitivity Analysis in Economics — what is it for?
Let me put it simply: sensitivity analysis in economics is the foundation for making effective management decisions in business.
The result of a business, that is, changes in its liquid capitalization (value), is influenced by many different factors.
And in order to understand in tangible terms — how much a change in a particular factor will change your balance sheet, in one direction or another, which is a fundamental systemic criterion for assessing its efficiency — sensitivity analysis is performed.
What factors?
Prices, raw materials and supplies, wages, products and their assortment, the length of time materials and goods remain in inventory, payment deferrals, investments, exchange rates, inflation, etc.
Even, for example, a cleaner whom you hire is a factor affecting your business.
In other words, everything affects a business — from internal factors to external ones.
A Basic Example
You (your business) hire a person. It is unlikely that you would attach any serious importance to this factor, which may affect your business, perhaps only slightly, through an increase in costs due to an increase in the payroll and the contributions associated with it.
And yet, ultimately, this factor, even if its impact may be tiny, will affect the overall economics of the business and its capitalization as early as the next reporting period.
Expenses increase → profit decreases → accumulated profit decreases → equity decreases → and, accordingly, the value of the business decreases.
One might say that this is obvious.
But actually seeing this as a specific change in the value of your business's projected balance sheet is something quite different.
After all, even an investor ultimately looks at the numbers. And at some point, it will be precisely these figures — especially if they correspond to real underlying values — that will determine how much they are willing to pay for such a business.
This is especially true if you look not only at today or tomorrow, but at a month, a year, and beyond.
Business is a long-term game. That is why it is important not simply to understand what will affect the business and how, but to see its tangible economic result — today, tomorrow, and in the future.
And this is where things get really interesting
Without your own comprehensive and properly constructed financial and economic business model, it is impossible to perform sensitivity analysis.
And therefore, it is impossible to make objective and correct management decisions.
I am not even talking about the impact of such factors as the product range, its turnover, loans, interest rates, etc., all of which constantly require businesses to make the right decisions for the sake of their economics.
In most cases, even today, businesses still operate by gut feeling, while all cash gaps are covered by a regular open credit line. With all the resulting consequences that I constantly mention.
It is extremely important to have your own model so that you can understand exactly how much and in what way the impact of a particular factor will cost the business.
Because there is a big difference between saying:
«Well, we hired one more person — what difference will it make?»
And something completely different is seeing in the model exactly how much money this decision will take away from the business, how its financial result will change, and what this will ultimately mean for its liquid value today, tomorrow, and so on.
That is exactly what sensitivity analysis in business economics is for.
