Introduction
Financial modeling is the practice of using spreadsheet programs to create models that evaluate the financial performance of business operations. Bottom up financial modeling is a more detailed approach to regular financial modeling, where instead of estimating the whole business as a complete entity, the business is instead broken down into smaller parts and estimated separately. This approach better approximates the structure and performance of the business.
Sensitivity analysis is an important part of any financial model that uses the bottom up approach. This involves examining the changes in outputs when individual assumptions are changed. Different scenarios can be assessed to better understand the impact of any proposed changes.
Key Takeaways
- Bottom up financial modeling is an in-depth approach to modeling the performance of a business
- Sensitivity analysis is key to understanding the potential impact of any changes
- Spreads heet programs are the most common tools used to develop financial models
- Modelers must pay attention to detail when creating scenarios and understanding changes in outputs
Purpose of Sensitivity Analysis
Bottom up financial modeling is used to assess the potential performance of a company. When done properly, this modeling can provide organizations with valuable insights into the risk and reward tradeoffs associated with different investment strategies. Sensitivity analysis is an important part of this process and is used to test the robustness of the underlying assumptions and to identify potential areas of risk.
Sensitivity analysis helps to identify the “drivers” of value. As the various inputs are adjusted, the impact on the outcome of the model is also detected. This allows organizations to understand how different economic and market factors interact with each other and how they can potentially affect the performance of the company’s investments.
Sensitivity analysis also helps to understand the input-output relationships of the financial model. By varying the inputs, organizations can identify any discrepancies between the expected and the actual output and take remedial action accordingly. This understanding of the input-output relationships ensures that the decision-making process is based on accurate and reliable information.
Finally, sensitivity analysis provides organizations with a tool to evaluate the probability of different scenarios. By examining the results of the different scenarios, organizations can identify which strategies are most likely to be successful and make more informed decisions.
Components of a Sensitivity Analysis
When it comes to understanding the sensitivity of a bottom up financial model, the components of a sensitivity analysis form the foundation for success. Such analysis requires an understanding of the key decision variables and how their range might affect the model output. The following points will provide an overview of the overall process of a sensitivity analysis.
Decision Variables
The first step in a sensitivity analysis is to identify the key decision variables. These decision variables typically have an associated range, so it is important to determine which ones will have the greatest impact on the model output. This typically requires an understanding of how the decisions of how the variables interact with one another, and how any change in one variable can affect the other.
Understand The Range Of The Variable
After the decision variables are identified, it is important to define what range those variables will take. In most cases, a range between a minimum and maximum is typically defined for the variable. This ensures that the model is considering the variable from its most extreme cases, so that any unforeseen change or extreme cases can be taken into account.
Assign Values For The Range
Once the range of the variable is defined, appropriate values must be assigned to the variable in order to calculate the output of the model. These values can be based on historic data, or can be determined using forecasting methods such as Monte Carlo. When assigning values to the variable, it is important to remember that all of the ranges should be considered and accounted for.
Analyze Historic Data
It is also important to analyze the historic data in order to understand the behavior of the key variables over time. Analyzing the past performance of the variables will allow for a better understanding of how they interact and how changes in one variable can affect the model output. Additionally, analyzing the historic data will help to identify any potential risks or trends that must be taken into account when making decisions.
Understanding the sensitivity of a bottom up financial model requires an understanding of the components of a sensitivity analysis. This includes an understanding of the key decision variables and how their range might affect the model output. It also requires assigning appropriate values for the range and analyzing historic data to gain some insight into the behavior of the variables over time. By following the steps outlined above, financial models can become more accurate and reliable.
Methods of Analogous Sensitivity Analysis
Analogous sensitivity analysis is a method that examines the sensitivity of a bottom-up financial model. This method is used to gain an understanding of the sensitivity of the financial assumptions within the model and to determine how changes in the inputs can affect the outcome of the model. The main methods used in analogous sensitivity analysis are outlined below:
Compare to a Benchmark
One method of analogous sensitivity analysis is to compare the results of the model against benchmark values. This helps to identify any areas in which the assumptions used in the model vary greatly from expected or typical values, which indicates areas in which the model is overly sensitive and may need further review. By comparing the model to a benchmark, potential areas of instability or sensitivity can be identified and addressed.
Calculate Net Present Value
Net present value (NPV) calculations are another common tool used in analogous sensitivity analysis. NPV provides a metric to evaluate the overall financial impact of a given project or investment and can be used to identify areas in which the assumptions in the model are overly sensitive. A higher NPV indicates a more desirable outcome and a lower NPV indicates a less desirable outcome, allowing for changes to be made to the inputs to adjust the output of the model.
Analyze Breakeven and Revenue Points
The breakeven and revenue points of the model can also be used to gauge its sensitivity. By analyzing these points, the impact of changes in the inputs can be assessed and areas in which the assumptions are highly sensitive can be identified. By understanding how changes to the inputs can affect the breakeven and revenue points, adjustments can be made to ensure that the model produces the desired results.
Understanding the sensitivity of a bottom-up financial model is an important part of decision-making. By using methods such as benchmark comparisons, NPV calculations, and breakeven/revenue point analysis, potential areas of sensitivity can be identified and addressed in order to ensure that the model is accurately reflecting the desired outcome.
Steps to Creating a Bottom Up Financial Model With Sensitivity Analysis
Explore the microeconomic data
Fundamental to any financial model is the ability to capture and accurately reflect the microeconomic data related to the business. When creating a Bottom Up Financial Model that utilizes sensitivity analysis it is essential to have a deep understanding of the overarching industry as well as the potential drivers, both qualitative and quantitative, that could significantly alter the financial outcomes.
Identify the key drivers
Once the microeconomic data has been gathered and explored, it is important to identify which of these drivers, if changed, could significantly impact the overall economic results of the business. These key drivers will be the focus of the sensitivity analysis and should be carefully considered.
Gather the data points
After identifying the key drivers all of the relevant data points associated with the drivers must be collected. This information must be accurate and up to date in order to provide the best possible model and analysis. To ensure the integrity of the model, the data must be continuously monitored and updated as needed.
Construct the model
Once the drivers and data points have been gathered, it is time to construct the model. The model should be built in such a way that it accurately reflects the microeconomic data associated with the underlying business, factoring in the relevant drivers. Once the model is complete, it is important to ensure it is clearly and concisely organized for ease of use and readability.
Conduct the sensitivity analysis
Once the underlying model is finished, the sensitivity analysis can begin. This analysis can include both quantitative and qualitative factors. The results of this analysis will inform the user of the potential upswings or downswings in the financial results of the business, should certain drivers change significantly.
- Create scenarios with potential changes in the key drivers to see the projected impact on the financial health of the business.
- Run scenarios to monitor the effects of different changes in the base inputs.
- Compare results across scenarios to identify optimal solutions.
Benefits of Bottom Up Financial Modeling with Sensitivity Analysis
Bottom up financial modeling with sensitivity analysis can provide more comprehensive, accurate results that can guide businesses in their decision-making process. Through bottom up modeling, companies can acquire further understanding of their financial data.
More in-depth accuracy
When financial models are adjusted for an increasing level of detail, bottom up modeling can provide more accurate information. This is because the results offer more precise financial models where pertinent parameters are taken into account. As defined by Deloitte, bottom up modeling consists of “starting from the most basic inputs and calculating the results from that” which provides a more involved approach.
Estimation of probability of success or failure
Through sensitivity analysis, a range of inputs can be evaluated and the results examined for the impact of variance on results. Given that the scenarios are varied, the probability of success or failure can be estimated. For example, if a company seeks to assess the likelihood of achieving a certain return on investment, this can be done through bottom up modeling with sensitivity analysis when various returns are accepted as outputs.
Ability to identify trends in the data
Given that bottom up modeling with sensitivity analysis can create deeper insights into the data, trends can be identified within the results. For example, an organization can assess the impact financial projections have under numerous situations by conducting multiple analyses. With increased sensitivity analysis of the parameters, trends can be identified in the financial data and better decisions can be made on the basis of these trends.
Conclusion
Bottom up financial modeling is an essential tool for any business, organization, or individual for understanding the financial implications of decision making. Sensitivity analysis is an integral part of this process as it helps to identify areas of financial risk, refine data for type of scenarios, and quantify the impact of the decisions that were made.
This article has covered the main principles of bottom up financial modeling and how sensitivity analysis plays a critical role within the process. The following are key points to keep in mind.
- Bottom up financial modeling is a process that helps identify the implications of a decision at an individual, departmental or organizational level.
- Sensitivity analysis is an integral part of the process as it helps to identify areas of financial risk, refine data for type of scenarios, and quantify the impact of the decisions that were made.
- There are three main types of sensitivity analysis that can be used, such as one-way, two-way, and three-way analysis.
- It is important to use sensitivity analysis to identify inputs which produce the greatest impact on a bottom up financial model.
The main advantage of bottom up financial modeling with sensitivity analysis is that it helps to understand the impact of different decisions on a project. Sensitivity analysis also helps to identify areas of risk and allow for better decision making. By focusing on the quantitative side of decision making, the use of sensitivity analysis can provide greater clarity and accuracy in understanding the financial impact of decisions.